Financial Instability and its Unexpected Tax Consequences

December 01, 2010 | Written by: Mark D. Olander, EA, USTCP
realtor holding up a key next to small model house


Since the worldwide financial crisis began in 2007, countless individuals and families have been facing their own personal economic troubles. Many folks have had no choice but to deplete retirement savings accounts and default on mortgage debt. Often it’s too late by the time they discover that these transactions have resulted in serious tax consequences. This month’s case shows how a professional audit representative from TaxResources can provide the lifeline you need to survive an unexpected tax audit during difficult financial times.

The members received a notice from the IRS with a proposed balance due of $84,500 for the 2008 tax year, an amount more than three times their annual income. The notice was triggered by six unreported 1099-C forms totaling around $250,000, identified by the IRS’s computerized document matching program. In addition, there was an unreported retirement plan distribution of $4,000. The IRS had assessed a 10% early distribution penalty on the retirement funds, interest of $4,300 and an Accuracy-Related Penalty for Substantial Tax Understatement of $13,400.

An IRS Form 1099-C is the document lenders issue to report the discharge of debt to debtors and the IRS. Discharged debt is considered taxable income, and the IRS requires taxpayers to report the information from 1099-C forms on their tax returns. Exclusions to the “cancelled debt as income” rule are available, but determining whether or not a taxpayer qualifies for one of them can be very complicated. Even more confusing is the reporting requirement when an exclusion is allowed. It’s no wonder that many taxpayers ignore the 1099-C forms they receive.

The members were assigned an Audit Representative with expert knowledge of the issues and tax consequences of cancelled debt. But it didn’t take an expert to notice that the 1099-C forms listed on the notice appeared to have been duplicated numerous times. In her initial review of the case, the Audit Representative also observed that the taxpayers had reported only $23,000 in wage income, which immediately got her to thinking that they may qualify to exclude the cancelled debt income under the insolvency provision if no other exclusion fit their circumstances.

The Audit Representative called the members and found out that the 1099-Cs had been generated by the “short sale” of their personal residence in 2008. She requested copies of any 1099-C forms they had received. When asked about the retirement account distribution, the members acknowledged that they had withdrawn funds from a retirement plan that year, but they had not reported it on their tax return because they had not received a 1099-R from the bank. The distribution had been taken due to disability and, not surprisingly, “financial instability.”

When she received the documentation from the members the Audit Representative was able to confirm that the IRS had counted the same cancellation of debt income six times. The Audit Representative questioned the members to find out if there were any equity lines or refinances included in the mortgage loan forgiven. If there were refinances she knew she would need to determine if the funds had been used for improvements on the home or something else that would make it “nonqualified debt” ineligible to be excluded under the qualified principal residence provision for excluding cancelled debt from income.

The Audit Representative determined that the entire amount of cancelled debt income was eligible for the qualified principal residence indebtedness exclusion. This wiped out the majority of the amount of taxes, interest and penalties due. She was able to shave another $400 off of the bill by demonstrating that the taxpayer qualified for the disability exception to the 10% penalty for early distribution of the retirement income. The end result was a balance due of a little more than $1,000 for the unreported retirement income, which was the only item that had been correctly reported on the original IRS notice.

The Audit Representative saved our members a small fortune in taxes. The members were thrilled that what had at first appeared to be a personal tax disaster turned out to be not so bad at all.

To learn more about the tax consequences of discharged debt, please refer to the TaxResources March 2010 tax alert: http://www.taxaudit.com/TaxAlerts/List
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