As we’re all aware, this decade’s Great Recession has dealt, and continues to deal, a significant blow to the budgets of many American families, leaving millions in debt, underwater in their mortgages, and looking for any means necessary to get back on a financially-healthy course. Now, we’re finding that tax time is also yielding it’s own set of challenges for some cash-strapped citizens.
In his recent New York Times article, “Paying the Price for Survival Tactics,” Charles Delafuente reports on how the I.R.S. treats many kinds of written-off debts, some distressed home sales, and many emergency withdrawals from retirement accounts as taxable income.
Debt Forgiven By A Lender
In his timely piece, Delafuente introduces the concept of “phantom income:” an amount a lender forgives but for which the debtor still owes tax. In your case, this taxable amount becomes essentially the difference between what the lender would have received from you and what it will receive under your new agreement. As Delafuente explains, “These taxes are imposed even if only the interest rate, not the amount of principal, is reduced. That happens, for example, to consumers who renegotiate credit card debt. A lender is supposed to issue a 1099-C form reporting forgiven debt, but that doesn’t always happen if the principal is not reduced.”
As is normally true in the tax world, there are exceptions to the forgiven-debt rule. Keep in mind, forgiven debt is not taxable income if it is discharged by bankruptcy, or if you are considered insolvent—whereby your liabilities exceed the fair market value of your assets—when the debt is forgiven.
While recent bailout measures enacted to help homeowners generally won’t trigger the forgiven-debt tax on a principal home, “foreclosures, short sales and other loss-of-home scenarios could bring on capital gains tax.” For example, if your home is worth significantly more than a mortgage and is repossessed and sold by the lender, you are entitled to the difference. As Delafuente explains, “The difference is a taxable profit, which will cause a capital gain. Fortunately for the masses, the first $500,000 on gains on a main home for couples ($250,000 for single taxpayers) may be covered by a tax exclusion. Further, nonrecourse mortgages, in which the lender can’t touch any assets other than the property, generally don’t cause such a gain.”
Aside from your mortgage, if you withdraw money prematurely from their retirement accounts because of a job loss or a reduction in hours, you will also face extra taxes. Holders of traditional I.R.A.’s and I.R.A. rollover accounts must pay 10 percent of any amount withdrawn before they reach 59 1/2 as a penalty on top of the traditional taxes on money taken out, which must be paid regardless of your age.
If you have a Roth I.R.A., you’ll face different rules. Your contributions—but not the account earnings—can be withdrawn without penalty after five years.
If you have an employer-sponsored plan, like 401(k)s and 403(b)s, you face yet another set of rules. For you, withdrawals are penalty-free if you left the employer that set up your plan after you turned 55. However, money rolled over to an I.R.A. from a former employer’s plan is subject to the 59 1/2-age rule.
Most 401(k) and 403(b) plans do not allow current employees to make withdrawals; instead they often have loan provisions. But another tax nightmare occurs if you have an outstanding loan and lose your job. In that case, you must repay the loan quickly or have the balance treated as a withdrawal, making it subject to tax and to the 10 percent penalty if you’re under 55, unless an equal-payment plan is used.
But remember, before borrowing from your retirement accounts, one of the best debt forgiveness plans comes from a personal bankruptcy. In these taxing times, a qualified bankruptcy attorney can help you conquer your fears before losing it all. Specifically, the bankruptcy attorneys at the Law Offices of John T. Orcutt offer a totally FREE debt consultation and now, more than ever, it’s time to take them up on their offer. Just call toll free to 1-888-234-4181, or during the off hours, you can make your own appointment right online at www.billsbills.com. Simply click on the yellow “FREE Consultation Now” button.