Beware! Canceled debt could cost you taxes

Cancellation of debt (COD) income is taxable as ordinary income. Internal Revenue Code section 61(a)(12) provides that gross income means all income from whatever source derived. COD income can arise in a number of areas, such as: Cancellation of credit card debt Foreclosure of personal residence, or Cancellation of an automobile loan There are two 1099 forms which can arise in a COD / foreclosure situation: Form 1099-A, Acquisition or Abandonment of Secured Property Form 1099-C, Cancellation of Debt. Form 1099-A is used when the lender acquires an interest in property that is security for the debt, or the lender knows or has reason to know that the property has been abandoned. Form 1099-C is used when the lender cancels debt of $600 or more without receiving anything of value in exchange for the cancellation. You should be aware of the interaction between these two forms. If, in the same calendar year a lender cancels a debt in connection with a foreclosure or abandonment of property with respect to the same debtor, the lender can file only Form 1099-C and still satisfy the Form 1099-A reporting requirements. If the lender files a consolidated Form 1099-C, that lender must complete box 5 (description of property) and box 7 (Fair Market Value, or FMV). These two forms, however, have much different tax consequences for the debtor. Form 1099-A results in a deemed disposition by the debtor. Thus, the debtor must calculate the gain or loss on the disposition as well as the character, excludability, and deductibility of any gain or loss. Form 1099-C results in ordinary income from the cancellation of indebtedness and generally must be included in income unless certain exceptions or exclusions under IRC section 108 are met. A consolidated 1099-A/1099-C results in both a deemed disposition and ordinary income from the cancellation of debt (unless any exceptions or exclusions apply). One area that gets a lot of attention and warnings about is the fair market value amount shown on the Form 1099. If you disagree with the amount shown, the first thing that you should do is contact the lender. Also, while the IRS presumes the FMV amount to be correct as shown on the 1099, you can dispute the amount if you provide information from reliable sources that support the amount you assert as the true value. Where the COD income gets reported on the individual tax return depends on the type of debt that is canceled. Report the taxable COD amount of any nonbusiness debt on Form 1040 or Form 1040NR, line 21. If the debt is related to a nonfarm sole proprietorship, report the taxable CODamount on Schedule C, line 6, or on Schedule C-EZ, line 1. If the debt is related to nonfarm rental activity, report the taxable COD amount on Schedule E, line 3. If the debt is related to farm debt (and taxpayer is a farmer), the taxable COD amount goes on Schedule F, line 10. If the taxpayer uses Form 4835, Farm Rental and Expenses, to report rental income based on crops or livestock produced by the tenant, report the taxable COD amount on line 6 of Form 4835. It is important to note that only taxable COD income is what gets reported. Example - If you have $5,000 of COD income and can exclude $1,000 of this income under a section 108 exclusion, you would report the $4,000 net taxable amount on the appropriate line of the applicable form or schedule. Here are the exceptions and exclusions that can account for the difference between total COD and taxable COD: Exceptions: Amounts otherwise excluded from income Certain student loans Deductible debt, for taxpayers using the cash method of accounting, and Price reduced after purchase Exclusions: Bankruptcy Insolvency Qualified farm indebtedness Qualified real property business indebtedness Qualified principal residence indebtedness, and Certain non-business debt of a qualified individual because of the Midwestern disasters First, you should know that there is a special rule dealing with nonrecourse debt. Nonrecourse debt is debt for which the taxpayer is not personally liable. COD rules differ based on whether or not there has been a disposition of the property. If there has been a disposition (for example, through a foreclosure, repossession or abandonment), no COD income is realized. Instead, the full amount of debt is included in the amount realized on the disposition. If there is no disposition – perhaps there was a workout situation – COD income can arise on forgiveness of nonrecourse debt. Bankruptcy. If you are under the jurisdiction of the court in a title 11 bankruptcy case, and the discharge is granted by the court, or is under a plan approved by the court, this exclusion applies. And, it takes precedence over the other exclusions. There are no dollar limitations on the amount you can exclude under section 108 in a title 11 bankruptcy case. Insolvency. Here, there is a dollar limit because the exclusion is limited to the extent of insolvency measured immediately before the discharge. The calculation is easy in theory – total liabilities immediately before the discharge minus the FMV of total assets at that time – but the calculation is more difficult in application because taxpayers generally do not have such a listing of assets and liabilities readily available. Qualified principal residence indebtedness. This exclusion applies to debt discharged on or after Jan. 1, 2007 and before Jan. 1, 2013. The maximum amount you can treat as qualified principal residence indebtedness is $2 million – or if married filing separately, $1 million. This must be qualified acquisition indebtedness, or debt incurred in acquiring, constructing or substantially improving the home, and secured by the home. It can also include refinanced debt with certain limitations having to do with the amount of qualified indebtedness on the original loan. Qualified acquisition indebtedness can also include the proceeds of a “home equity” loan used to substantially improve the home. If the mortgage debt is used for nonqualified purposes – such as to pay off credit card debts or student loans - it is not qualified acquisition indebtedness and cannot be excluded under this provision. However, such debt may qualify for exclusion under another provision, such as insolvency. Once you have a situation in which there is nonqualified debt, the ordering rule comes into play. The ordering rule says that if only a part of the loan is qualified principal residence indebtedness, the exclusion for discharged qualified principal residence indebtedness applies only to the extent that the amount discharged exceeds the amount of the loan, immediately before the discharge, that was not qualified principal residence indebtedness. Example: Let’s say we have an outstanding mortgage balance of $750,000 We’ve refinanced the mortgage for $850,000 – so we’ve acquired an additional $100,000. We used that $100,000 to buy a car and pay off credit card debt -- that makes it nonqualified debt because it was used for nonqualified purposes. Assume also that the lender forecloses, and sells the house for $735,000. The lender also cancels the remaining $115,000 of debt. The ordering rule says we must first subtract the $100,000 of nonqualified debt – the amount we used to buy a car and pay off credit cards – from the $115,000 the lender canceled at foreclosure. This leaves us with only $15,000 eligible for exclusion as qualified principal residence indebtedness. The remaining $100,000 must be included in income unless another exception or exclusion applies – for instance, insolvency. Because this example involves a foreclosure, keep in mind that the taxpayer in this situation would also need to calculate the gain or loss on the disposition of the home. Since we are dealing with a personal residence, any gain would potentially be eligible for exclusion under section 121 – any loss would be a nondeductible loss. Claiming Exclusions. Use Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to let the IRS know that you are claiming such an exclusion, and to reduce tax attributes due to the discharge of indebtedness. Attach Form 982 to the tax return. The IRS will look for Form 982 as part of the document matching program. Use Part I of Form 982 to show the reason, or reasons, for the exclusion and the total amount excluded. Essentially, you check the box or boxes relating to the exclusion you are entitled to on line 1, and enter the total amount of the exclusion on line 2. Remember, if the exclusion is not the full amount of the debt discharged, the taxable amount gets reported on the tax return, as discussed earlier. The rules for reduction of tax attributes. Essentially, the rules say that if you exclude income from the discharge of indebtedness, you must also reduce tax attributes. Tax attributes are certain credits, losses, and deductions that you may have that would give you a tax benefit some time in the future. The reduction of tax attributes is made after determination of your tax liability for the year of the discharge. Internal Revenue Code section 108(b)(2) lists the general order in which tax attributes must be reduced: One: net operating loss and NOL carryover Two: general business credit carryover Three: minimum tax credit Four: capital loss and capital loss carryover Five: basis Six: passive activity loss and credit carryover Seven: foreign tax credit However, there is an election which can be made under section 108(b)(5) to first reduce the basis of depreciable property, and there is also a special rule for qualified principal residence indebtedness. This rule essentially says that if you are excluding income based only on the qualified principal residence indebtedness exclusion, you only need to reduce the basis of the residence – and only if you retain ownership. The basis reduction rules are generally one of the most relevant to nonbusiness taxpayers. Basis includes the basis of property held at the beginning of the tax year following the year of the discharge. And the basis reduction rules must also be made in a specific order – and you must allocate the reduction within each category in proportion to the adjusted basis. To help figure this out and do the calculations properly, refer to Publication 4681 for individuals, titled Canceled Debts, Foreclosures, Repossessions, and Abandonments. You will use part two of Form 982 to show the reduction of tax attributes. Be aware that the amount in part two will not necessarily equal the part 1 exclusion. The above information was obtained from www.IRS.gov.

Business.gov - Official Business Link to the U.S. Government

Business.gov - Official Business Link to the U.S. Government

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You may owe taxes in 2010 and here is why

With 2009 nearly half over, the Internal Revenue Service reminds individual taxpayers there is no better time to check their 2009 federal income tax withholding levels to make sure they do not face any surprises when returns are due next spring.

The Making Work Pay Credit lowered tax withholding rates this year for 120 million American households. However, particular taxpayers who fall into any of the following groups should review their tax withholding rates to ensure enough tax is withheld:

• multiple job holders
• families in which both spouses work
  
• workers who can be claimed as dependents by other taxpayers and pensioners.

Because retirees typically have withholding from their pension payments, pension plan administrators or pension payors should be aware of the optional adjustment procedure for pension withholding announced in Notice 1036-P, Additional Withholding for Pensions for 2009.

Also the following groups need to be aware because they receive this year’s one-time $250 economic recovery payment . The Making Work Pay credit will be reduced by the $250 payment amount. It may be possible to end up owing taxes.

• Social security beneficiaries,
  
• supplemental security income recipients
• disabled veterans
  
• railroad retirees
  

Failure to adjust your withholding could result in potentially smaller refunds or may cause you to owe tax rather than receive a refund next year.

So far in 2009, the average refund amount is $2,675 and 79 percent of all returns received a refund.

In addition, the IRS reminds unemployed workers that the first $2,400 of unemployment benefits they receive during 2009 are tax-free for federal income tax purposes. People who expect to receive more than that should consider having tax withheld from their benefit payments in excess of $2,400. Use Form W-4V, Voluntary Withholding Request, or the equivalent form provided by the payer to request withholding to begin or end.

Taxpayers should visit IRS.gov for more information about how to adjust federal income tax withholding. The Web site also has details on various tax incentives in the American Recovery and Reinvestment Act as well as downloadable forms and publications. Free tax forms and publications are also available by calling 1-800-TAX-FORM (1-800-829-3676).

Links:

• The Making Work Pay Credit
• Notice 1036-P, Additional Withholding for Pensions for 2009
• IRS withholding calculator
• Publication 919, How Do I Adjust My Withholding?
• Related News Releases and legal guidance
• Publication 4766, Making Work Pay Credit and Form W-4 Withholding Certificate
  

Video: Making Work Pay - Withholding Calculator

Audio: Making Work Pay - Withholding Calculator

Tips for Choosing a Tax Preparer from www.irs.gov

Tips for Choosing a Tax Preparer

If you pay someone to prepare your tax return, choose that preparer wisely. Taxpayers are legally responsible for what's on their own tax returns even if prepared by someone else. So, it is important to choose carefully when hiring an individual or firm to prepare personal returns. Most return preparers are professional, honest and provide excellent service to their clients. Here are a few points to keep in mind when someone else prepares your return: A Paid Preparer is required by law to sign the return and fill in the preparer areas of the form. The preparer should also include their appropriate identifying number on the return. Although the Preparer signs the return, you are responsible for the accuracy of every item on your return. In addition, the preparer must give you a copy of the return. Review the completed return to ensure all tax information, your name, address and Social Security number(s) are correct. Make sure that none of these spaces is left blank. Review and ensure you understand the entries and are comfortable with the accuracy of the return before you sign. Never sign a blank return, and never sign in pencil. If you have provided specific authorization in a power of attorney filed with the IRS, you may have copies of notices or refund checks mailed to your preparer or representative; but only you can sign and cash your refund check. For further information on Powers of Attorney, refer to Topic 311. A Third Party Authorization Check Box on Form 1040 allows you to designate your Paid Preparer to speak to the IRS concerning how your return was prepared, payment and refund issues and mathematical errors. It's important for taxpayers to find qualified tax professionals if they need help preparing and filing their tax returns. Unqualified tax preparers may overlook legitimate deductions or credits that could cause clients to pay more tax than they should. Unqualified preparers may also make costly mistakes causing their clients to incur assessed deficiencies, penalties, and interest. Here are some suggestions to consider when hiring a tax professional: A paid preparer must sign the return as required by law. Avoid preparers who claim they can obtain larger refunds than other preparers. If your returns are prepared correctly, every preparer should derive substantially similar numbers. Beware of a preparer who guarantees results or who bases fees on a percentage of the amount of the refund. A practitioner may not charge a contingent fee (percentage of your refund) for preparing an original tax return. Understand that the most reputable preparers will request to see your receipts and will ask you multiple questions to determine your qualifications for expenses, deductions and other items. By doing so they have your best interest in mind and are trying to help you avoid penalties, interest or additional taxes that could result from an IRS examination. Choose a preparer you will be able to contact and one who will be responsive to your needs. Ask who will actually prepare the return before engaging services. Avoid firms where your work may be delegated down to someone with less training or some unknown worker. You should know exactly who works with your tax matters at all times and how to contact him or her; after all, you are paying for it. Determine if the preparer is exporting your return to a foreign country for preparation. Foreign countries do not have the same security and privacy laws as the United States nor is there any recourse should your information be compromised as a result of lax or nonexistent privacy procedures. Investigate whether the preparer has any questionable history with the Better Business Bureau, the state's board of accountancy for CPAs, the state's bar association for attorneys or the IRS Office of Professional Responsibility (OPR) for enrolled agents or the oversight agency in states that license or register tax preparers. Determine if the preparer's credentials meet your needs or if your state mandates licensing or registration requirements for paid preparers. As of 2008, California and Oregon are the only two states that regulate paid tax preparers. Is he or she an Enrolled Agent, Certified Public Accountant (CPA) or Tax Attorney? Only attorneys, CPAs and enrolled agents can represent taxpayers before the IRS in all matters including audits, collection actions and appeals. Other return preparers may represent taxpayers only in audits regarding a return that they signed as a preparer. Find out if the preparer is affiliated with a professional organization that provides or requires its members to pursue continuing education and holds them accountable to a code of ethics. Check IRS.gov for information regarding abusive shelters and other tax schemes and scams. Remember, if it sounds too good to be true, chances are it is. The IRS can help many taxpayers prepare their own returns without the assistance of a paid preparer. Before seeking a paid preparer, taxpayers might consider how much information is available directly from the IRS through the IRS Web site. Check out these helpful links: e-file for Individual Taxpayers Free File Free Tax Return Preparation For You by Volunteers Unfortunately, unscrupulous tax return preparers do exist and can cause considerable financial and legal problems for their clients. Examples of improper actions by unscrupulous preparers include the preparation and filing of false paper or electronic income tax returns that claim inflated personal or business expenses, false deductions, unallowable credits or excessive exemptions. Tax evasion is both risky and a crime, punishable by up to five years imprisonment and a $250,000 fine. Remember, no matter who prepares a tax return, the taxpayer is legally responsible for all of the information on that tax return. Report suspected tax fraud and abusive return preparers by completing Form 3949-A and mailing it or a letter with similar information to: Internal Revenue Service Fresno, CA 93888

Page Last Reviewed or Updated: January 02, 2009

Simplifying management of your finances

If you want to get a hold of your finances review my suggested list of actions you can take to diagnose your situation and start fixing your financial problems.

1. Write down the particular issues that you have with your finances. Consider the following examples and then create your customized list.

• Several bank accounts at different institutions
• Several credit card accounts
  
• Commingling of personal and business expenses in the same bank and credit card accounts
  
• Retirement plans at several brokerage house, or with various previous employers
• Inconsistency on the use of payment options: you pay some bills online, some with checks, some by direct draft, etc. making hard to keep a handle on all of it.
• You have several credit cards, and are not familiar with their terms.
• Your files are in disarray. You can't find the tax records you need, the insurance documentation to file a claim, the receipts to claim insurance on equipment that you bought that is under warranty.
• You are "drowning" on a "sea" of receipts from business trips and spending valuable personal time preparing financial reports
• You are tired of doing it all and are considering options to help you handle them and free up your time.
  

2. Write down the changes that you would like to make.

• Do you want to organize your files, but feel overwhelmed by the prospect?
  
• Do you want to know where you money is going so you can adjust your spending, but don't have the time or the inclination to gather the information and prepare a report?
  
• Do you want to take a hold of your retirement accounts to make it easier to track your investments, but are unsure on how to proceed?
• Do you want to get help making the payments, reconciling the accounts, and keeping your files in order?

3. Decide on the changes you desire and consult a financial professional to help you get started. Interview the professional, check his or her credentials and get references. Contact the governing boards to confirm that they are members in good standing. Ask how they protect your financial information.

5. Get an engagement letter that clearly specify what work will be completed and how . Make sure that you are clear on what is included and what is not.