FAQ: What constitutes income from the cancellation of debt?

FAQ: What constitutes income from the cancellation of debt?   Debt that a borrower no longer is liable for because it is discharged by the lender can give rise to taxable income to the borrower. Debt forgiveness income or cancellation of debt income (”COD” income) is the amount of debt that a lender has discharged or canceled. However, in many situations, the canceled debt is excluded from taxable income.Credit cards, car loans and mortgage debt are three of the most common consumer debts, yet many individuals don’t know the tax rules surrounding discharges of these debts by lenders. In general, almost all types of discharged debt will be includable in the borrower’s taxable income, unless a specific exclusion applies. The creditor will generally report COD income to the IRS and to the debtor, using Form 1099-C, Cancellation of Debt, even if an exclusion applies. The creditor may not be aware that the debtor can exclude the COD income. We can help you determine whether an exclusion applies. Exclusions and reduction of attributes There are four situations where cancelled debt does not result in taxable income: 1. The debt has been discharged through a bankruptcy proceeding under Title 11; 2. Insolvency (your total debts exceed your total assets); 3. The debt is due to a qualified farm expense (”qualified farm indebtedness”); and 4. The debt is due to certain real property business losses (”qualified real property business indebtedness”). When canceled debt is excluded from income, the debtor may be required to reduce tax attributes, such as a net capital loss or the basis of property. The reduction of attributes must be reported on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attached to your federal income tax return. Other exclusions may apply to student loans, disaster victims, gifts, general welfare payments, and payments that would have been deductible. Mortgage debt forgiveness For a limited period of time, certain mortgage debt that is discharged by the lender is excludable from COD income and therefore does not result in taxable income to homeowners. This debt is generally referred to as “qualified principal residence indebtedness.” The cancellation of qualifying mortgage debt is excludable from income if it is incurred with respect to the taxpayer’s principal residence for “acquisition” debt forgiven on or after January 1, 2007 and before January 1, 2013. Acquisition debt is indebtedness secured by the residence and incurred in the acquisition, construction or substantial improvement of the residence. Certain debt used to refinance the debt is also eligible. Debt forgiven on a second home or rental property does not qualify for the exclusion. Example. Anne’s principal residence is subject to a $300,000 mortgage debt. Anne’s creditor forecloses on the property in September 2010. Due to the depressed real estate market, Anne’s home sold for $220,000. The creditor forgives the other $80,000 of debt. Anne has COD income totaling $80,000 ($300,000 - $220,000). Credit card and car loan debt Noticeably absent from the specific exceptions to COD income are two of the biggest consumer debt items: credit cards and car loans. Credit card debt or an unpaid debt on a car loan that is forgiven by the lender is includable in gross income, unless the debtor is bankrupt or insolvent. The lender will report the amount of forgiven debt on Form 1099-C, Cancellation of Debt. Example. Michael has an outstanding credit card bill of $7,400. Michael cannot pay the total amount but reaches a compromise with his credit card company in which he settles the debt for $4,000. Assuming the debtor is not bankrupt or insolvent, the Internal Revenue Code treats him as having realized a personal net gain (and COD income) of $3,400, even though he did not actually receive any money. The credit card company will report the $3,400 as COD income on Form 1099-C, and the debtor must include it in his gross income. Reporting If you had debt discharged in 2009 that does not qualify for an exception, you must include the amount of cancelled debt in your gross income on your tax return. If you have questions about COD income, the exclusions from income, or your reporting responsibilities, please contact our office.

Congress turns focus to economy; Senate readies jobs bill

Fresh from its Presidents’ Day recess, Congress has shifted its priority from passing healthcare reform to the economy and readying a jobs bill to jumpstart hiring. The bill is expected to be in the neighborhood of $100 billion. On February 11, the Senate Finance Committee (SFC) released a draft version of an $85 billion jobs and tax incentives package. However, the SFC’s bill was subsequently scaled back by Senate Majority Leader Harry Reid, D-Nev., who has instead offered a pared-down version of the measure. Reid’s bill would include four initiatives originally proposed in the SFC’s jobs package. Reid’s bill would provide an employer payroll tax exemption for new hires, Code Sec. 179 expensing, extension of the Highway Trust Fund, and an expansion of the Build America Bond program.

Hiring incentives

The centerpiece of Reid’s proposed bill is a $13 billion incentive for businesses to hire unemployed individuals. Private sector businesses that hire qualified workers after the date of enactment and before January 1, 2011 would be exempt from the 6.2 percent Social Security payroll tax (up to the maximum Social Security wage of $106,800) for qualified new hires. A qualified new hire is an individual who has not been employed for more than 40 hours during the 60-day period prior to employment. The incentive would not apply to new hires related to the employer or public sector employees.

Code Sec. 179 expensing

The Reid bill would also extend enhanced Code Sec. 179 expensing for qualified property placed in service in tax years beginning in 2010. As in 2008 and 2009, taxpayers would be able to expense up to $250,000 of qualified Code Sec. 179 expense property. This amount would be reduced is the property placed in service during the tax year exceeds $800,000.

Bonus depreciation/Extenders up in the air

Noticeably absent from Reid’s proposed bill is an extension of bonus deprecation as well as the extension of a host of popular individual, business, charitable, and energy tax incentives that expired after December 31, 2009. These include the state and local sales tax deduction, additional standard deduction for real property taxes, New Markets Tax Credit, and the research tax credit. However, it is anticipated that Congress may deal with tax incentives in subsequent legislation.

Estate tax

In December, the House voted to extend the 2009 estate tax regime through December 31, 2010. However, the Senate has not acted on the House’s bill, nor unveiled a version of its own estate tax bill. Congress will likely deal with the estate tax after it passes jobs legislation.

COBRA
Eligibility for COBRA premium assistance will expire after February 28, 2010. Although the SFC’s jobs bill would extend eligibility for COBRA premium assistance through May 31, 2010, Reid’s bill would not.

Our office will keep you posted on these significant legislative developments.

IRS survey reveals increased tolerance of “a little” cheating

The IRS Oversight Board has released its annual Taxpayer Attitude Survey. According to the survey, the percent of taxpayers who find it acceptable to cheat on their income taxes increased from 9 percent in 2008 to 13 percent in 2009. The 2009 survey was based on interviews of 500 men and 500 women during August 2009.

Tolerance for cheating rises

Approximately 9 percent of survey respondents believe “a little” cheating on an income tax return is tolerable, and 4 percent endorse “as much cheating as possible.” The percentage of respondents who said that cheating was “not at all” acceptable decreased from a high of 89 percent to 84 percent in 2009.

At the same time, 95 percent of respondents completely or mostly agreed that “it is every American’s civic duty to pay their fair share of taxes.” Moreover, 92 percent agreed that cheaters should be held accountable. Fear of an audit has the greatest influence over individuals’ honest reporting of their taxes.

IRS services

The percent of taxpayers viewing various IRS services as very important generally declined across-the-board. For example, 70 percent of respondents (down from 78 percent in 2008) found it very important for the IRS to have a toll-free helpline. Additionally, there was a drop from 69 to 64 percent of respondents who viewed it very important for a website to provide information, and a drop from 55 percent to 46 percent of respondents who viewed it as very important to have community tax clinics.

Withdrawals from retirement savings: Tough rules may change

March 2010 tax compliance calendar

February 2010 tax compliance calendar

As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important tax reporting and filing data for individuals, businesses and other taxpayers for the month of February 2010.

February 3

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates January 27-29.

February 5

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates January 30-February 2.

February 10

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 3-5.

February 10

Employees who work for tips. Employees who received $20 or more in tips during January must report them to their employer using Form 4070.

February 12

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 6-9.

February 16

Monthly depositors. Monthly depositors must deposit employment taxes for payments in January.

February 18

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 10-12.

February 19

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 13-16.

February 24

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 17-19.

February 26

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 20-23.

Congress approves 2009 deductions for 2010 Haiti earthquake donations

Congress has passed, and the president has signed, legislation allowing taxpayers to claim a deduction on their 2009 federal tax return for qualified Haiti disaster relief contributions made after January 11, 2010 and before March 1, 2010.

The bill gives taxpayers the option of claiming a deduction on their 2009 or 2010 tax returns for 2010 donations to a domestic U.S. charitable organization assisting Haiti. Taxpayers entitled to the deduction include both individuals and corporations.

However, taxpayers must itemize their deductions in order to take advantage of the early deduction. Additionally, the donation must be monetary. Taxpayers may not claim a 2009 tax deduction for 2010 contributions of marketable securities or other property that is easily convertible into cash. While donations by check or credit qualify, donations of food are not currently eligible. However, at least one Congressional proposal has promised to change this. We will keep you posted.

We encourage you to explore this option and look forward to helping you plan your tax position for a truly worthy donation.

IRS provides new first-time homebuyer credit form

A new Form 5405, First-time Homebuyer Credit and Repayment of the Credit, is now available for taxpayers claiming the credit on their 2009 income tax return. Because taxpayers are required to file a paper version of this form and new documentation requirements must accompany the form, the IRS reported that delivery of refunds may be slower than normal.

Taxpayers purchasing a home for the first time during 2009 may claim a credit equal to 10 percent of the purchase price of the principal residence with a maximum of $8,000 (or $4,000 for married couples filing separate returns). The Worker, Homeownership, and Business Assistance Act of 2009 also created a reduced tax credit (up to $6,500) for taxpayers who are qualified long-time residents of a home, but purchase a new principal residence during 2009.

To claim the credit for the 2009 tax year, taxpayers are now required to include documentation to substantiate their claim, in addition to their paper return. Required documentation includes a settlement statement in the form of a properly executed HUD-1 or a copy of the certificate of occupancy where a settlement statement is unavailable for a newly constructed home. Taxpayers claiming the reduced credit because they are qualified long-term residents should attach Form 1098, Mortgage Interest Statement, property tax records, or homeowner’s insurance records with their return.

Please let us know if you purchased a new home during 2009, and we will be sure to inform you of what documents you will need to gather to file your return and claim the credit.

How Do I … Convert a Traditional IRA to a Roth IRA?

People are buzzing about Roth Individual Retirement Accounts (IRAs). Unlike traditional IRAs, “qualified” distributions from a Roth IRA are tax-free, provided they are held for five years and are made after age 59 1/2, death or disability. You can establish a Roth IRA just as you would a traditional IRA. You can also convert assets in a traditional IRA to a Roth IRA.

Before 2010, only taxpayers with adjusted gross income of $100,000 or less were eligible to convert their traditional IRA (provided they were not married taxpayers filing separate returns). Beginning in 2010, anyone can convert a traditional IRA to a Roth IRA, regardless of income level or filing status.

Comment: While you can only contribute a maximum of $5,000 to a Roth IRA for 2010 (plus a $1,000 catch-up contribution if you are over age 50), you can convert an unlimited amount from a traditional IRA.

Conversion is treated as a taxable distribution of assets from the traditional IRA to the IRA holder, although it is not subject to the 10 percent tax on early distributions. While paying taxes on conversion is undesirable, the advantages of holding assets in a Roth IRA usually outweigh this disadvantage, especially if you will not be retiring soon. Furthermore, if you convert assets in 2010, you have the option of including them in income in 2011 and 2012 (50 percent each year) instead of 2010.

Comment: Generally, this income-splitting would be advantageous to any taxpayer who does not expect a sharp increase in income in 2011 or 2012. A wildcard factor is that the lower income tax rates that have been in effect since 2001 will expire after 2010 and could increase in 2011.

There are four ways to convert a traditional IRA to a Roth IRA:

• A rollover - you receive a distribution from a traditional IRA and roll it over to a Roth IRA within 60 days;
• Trustee-to-trustee transfer - you direct the trustee of the traditional IRA to transfer an amount to the trustee of a Roth IRA;
• Same-trustee transfer - the trustee of the traditional IRA transfers assets to a Roth IRA maintained by the same trustee; or
• Redesignation - you designate a traditional IRA as a Roth IRA, instead of opening a new Roth account.

Comment: The account holder does not have to convert all of the assets in the traditional IRA.

Another advantage of converting assets from a traditional IRA to a Roth IRA is that you can change your mind and put the assets back into the traditional IRA. This is known as a recharacterization. You have until the due date, with extensions, for the return filed for the year of conversion. Thus, if you convert assets in 2010, you have until mid-October in 2011 to undo the conversion.

This ability to recharacterize the conversion allows you to use hindsight to check whether your assets declined in value after the conversion. Since you are paying taxes on the amount converted, a decline in asset value means that you paid taxes on phantom income that no longer exists. However, if you convert assets into multiple Roth IRAs, you can choose to recharacterize the assets in a Roth IRA that decreased in value, while maintaining the conversion for a Roth IRA’s assets that appreciated in value.

The use of a Roth IRA can be a savvy investment, but whether to convert assets is not an easy decision. If you would like to explore your options, please contact this office.

2010 filing season gets underway; IRS expects many early filers