You've borrowed money and can't repay it. One day the lender tells you that you do not have to repay what you owe. Are you off the hook? Not with Uncle Sam. You still may owe income taxes on that "forgiven" loan.
With the economy tilting toward recession, more of you may find yourself in this situation. "There's no free lunch," says tax attorney Harry Zimmerman of Austin, Tex. "There are few tax loopholes for borrowers or lenders."
There are, however, simple rules and calculations both borrowers and lenders should know, says Zimmerman, a contributing author to Bender's Federal Tax Service. The rules put you in compliance with the tax laws. What's more, they enable you to maximize your tax benefits.
With few exceptions, a forgiven debt is considered taxable income for the borrower. One exception occurs when a debt is forgiven while you are in bankruptcy. Another occurs when you are insolvent.
What does "insolvency" mean? Calculate your net worth by matching your assets against your liabilities. But it's not quite that simple. When determining insolvency for tax purposes, you do not have to include as assets property (such as your homestead) that would be exempt from creditors' claims if you were to file for bankruptcy, according to Zimmerman. However, if you exclude assets, you also must exclude the related liabilities (such as the mortgage on your home).
Zimmerman cites this example. If at the time a debt is forgiven forgiven your assets consist of $10,000 cash, a house valued at ** $250,000, $50,000 in stocks and a vacation duplex worth $100,000, your total assets are $410,000. If at the same time your liabilities include a mortgage on your home for $150,000 and a duplex mortgage for $200,000, your liabilities would total $350,000. By subtracting your liabilities from your assets, you would have a net worth of $60,000 and are solvent.
However, when calculating insolvency for tax purposes, you could leave out your homestead and mortgage since they would exempt assets under many states' bankruptcy laws. Therefore, your assets are only the $10,000 cash, $50,000 in stocks and the $100,000 duplex, for a total of $160,000. Your only remaining liability is your duplex mortgage of $200,000. Thus, you have a net worth of negative $40,000 and are considered insolvent.
"Certain times are better than other times to have a debt forgiven," Zimmerman says. "A debt can be considered forgiven when the statute of limitations for enforcing the debt has passed at the time of foreclosure, if the lender agrees you have no more personal liability. Pay very close attention to the timing because the moment of forgiveness determines when the amount forgiven must be included in income. You may be insolvent today and therefore able to avoid taxation. But four years from now when the statute of limitations has passed you may be making big money, no longer insolvent and able to shelter the income. If you have not handled the timing of your loan forgiveness carefully, you may be penalized."
On the flip side, if you are the lender and you are not in the business of lending money, you can claim a tax deduction if the debt becomes worthless. But you can only claim that deduction when you know for sure that this personal loan will never be repaid.
"The unpaid loan now is treated as a non-business bad debt and is grouped with other short-term capital losses, regardless of how long you have had the debt. When you ultimately group all of your capital gains and losses together, you can deduct capital losses only against capital gains, plus $3,000 of ordinary income. The rest must be carried forward to be deducted in future tax years," Zimmerman explains.
Does that sound complicated? It is. Here's an example to help you understand it. If in 1990, you show no capital gains or losses, but you have determined that a friend will never pay you the $5,000 he borrowed from you, you can show the $5,000 non-business bad debt as a capital loss on your tax return for 1990. You will take a deduction of $3,000 in 1990, and the other $2,000 must be carried forward to 1991.
How to avoid such complications? "Neither a borrower nor a lender be," Shakespeare warned us four centuries ago.
FRIDAY: What to do when you can't sell your house
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