Dealing with debt can be a stressful and overwhelming experience. Imagine, though, finally having a weight lifted off your shoulders when a creditor cancels or forgives a portion of your outstanding debt. While the relief might be immense, it’s essential to understand that canceled debt can have significant tax implications. Many individuals are unaware that in certain circumstances, forgiven debts can be considered taxable income by the IRS. So, are canceled liabilities taxable? In this article, we will review the concept of canceled debt and its potential tax implications.
Understanding Canceled Debt
Canceled or forgiven debt occurs when a creditor releases a borrower from the obligation to repay a portion or the entirety of a debt. This situation typically arises when borrowers face financial hardships, negotiate debt settlements, or undergo bankruptcy proceedings. The canceled debt can encompass various types, including credit card debt, mortgages, personal loans, or business debts.
Tax Consequences
The IRS generally considers canceled debt as taxable income, which can come as a surprise to many borrowers. From the IRS’s perspective, forgiven debt is like receiving cash or other income, thus making it subject to taxation. So, although you don’t have to repay the debt, you might have to pay taxes on the amount forgiven. If necessary, it is typically paid in the year it was canceled.
Exceptions
Fortunately, the IRS provides certain exceptions that can exclude canceled debt from being taxable income in specific situations. Some of these include:
Bankruptcy. Canceled debt discharged through a bankruptcy proceeding is generally not taxable. This exclusion applies to both Chapter 7 and Chapter 13 bankruptcies.
Insolvency. If you were insolvent immediately before the debt cancellation, the canceled debt may not be taxable. This basically means your liabilities exceed your assets. You must file IRS Form 982 to claim this exclusion.
Qualified Principal Residence Indebtedness. The Mortgage Forgiveness Debt Relief Act of 2007 allows taxpayers to exclude up to $2 million ($1 million for other filing statues) of forgiven mortgage debt on their primary residence for years 2007 through 2020. This act also applies to discharged debt in 2021 if there was a written agreement in place in 2020. In addition, The Consolidated Appropriations Act (CAA) of 2020 excludes qualified canceled mortgage debt, up to $750,000 for married couples and $350,000 for other filers, from taxable income for tax years 2021 through 2025.
Some Student Loan Forgiveness. Some student loans are canceled after working in a certain profession for a specified number of years. Some student loan forgiveness in the years 2021 through 2025 are not considered taxable income.
Tax Reporting and Documentation
For canceled debt that qualifies as taxable income, the creditor must report the forgiven amount on Form 1099-C, Cancellation of Debt. Form 1099-C reports all eligible canceled debt of $600 or more per occurrence. Taxpayers should note that if they had debt under $600 that was canceled, it still needs to be reported as income, even if they don’t receive a 1099-C. The debtor should receive this form from the creditor. They must include the forgiven debt in their annual income whenif it’s not an excluded debt. However, if your debt does fall under one of the IRS’s exclusions, you should still file your return with Form 1099-C to acknowledge it. In addition, if you receive Form 1099-C after filing your tax return, you should file an amended return and include the Form 1099-C. Not doing so may raise some red flags with the IRS that can result in a tax audit. Finally, if there is an error on your Form 1099-C, you should contact the creditor immediately to request a corrected version.
Tax Help for Those with Canceled Liabilities
Remember, you should always consult the help of a knowledgeable tax professional if you are unsure about your tax situation. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers with tough tax situations.
Today, Optima Tax Relief’s Lead Tax Attorney, Phil Hwang, discusses his 5 top tips for how to avoid an IRS audit.
File Your Taxes: Some taxpayers don’t file because they think they don’t have to. The minimum requirement to file a tax return depends on your filing status and income, but generally most U.S. citizens and permanent residents need to file. Remember, if you don’t file when you’re required to, you will be hit with IRS penalties and interest. The IRS could also file a tax return on your behalf. While this might sound like a burden lifted off your own shoulders, this could be much worse than filing yourself because it can result in owing more taxes. You can use the IRS’s online Interactive Tax Assistant to find out if you need to file a tax return.
Report All Your Income: Failing to report all your income is the quickest way to being audited by the IRS. Keep in mind that the IRS receives copies of every W-2, 1099, and other tax forms that you receive. They know exactly how much you earned in the previous year and if your reported income does not match what they have on file, you’re much more likely to be audited.
Use Common Sense with Business Expenses: This tip is for the self-employed filers. The IRS requires all business expenses to be ordinary and necessary to be deductible during tax time. This means it should be common for your industry and necessary for the production of income. Excessive meals and entertainment, trips taken for non-business purposes, and commuting costs are examples of nondeductible business expenses.
Keep Good Records of Income and Expenses: Keeping good records of income and expenses can not only help you monitor the progress and financial well-being of your business, but also keep track of your deductible expenses, prepare your tax returns, and substantiate claims made on your tax returns. The IRS recommends keeping returns, records, and other tax documents for at least three years.
Be Wary of Multi-Year Losses: If your business consistently reports losses during tax time, the IRS will likely audit you. In addition, the IRS only allows you to write off losses for three of the five previous tax years. If you can’t prove your business is beginning to turn a profit, even a small one, the IRS can categorize your business as a hobby, at which point you will be unable to deduct any of your expenses.
Tune in next Friday for another episode of “Ask Phil” where Phil will review common IRS tax forms.
If You Think You’re at Risk of Being Audited by the IRS, Contact Us Today for a Free Consultation
If you have anyone doing work around your home, it’s possible they may be considered household employees. Consequently, you’ll have some additional responsibilities at tax time, including filing a Schedule H. Schedule H reports household employment taxes to the IRS. Here’s an overview of Schedule H.
What is Schedule H?
Schedule H, Household Employment Taxes, is a form that household employers use to report household employment taxes to the IRS. So, it’s important to understand which employees qualify as a household employee and not independent contractors. If a person comes to your home to perform work one time or occasionally, they are likely independent contractors. These are typically plumbers, occasional babysitters, roofers, and others who run their own businesses. On the other hand, if your employee is someone who you give regular tasks to, they are likely considered a household employee. Housekeepers, live-in nannies, drivers, caretakers and regular babysitters are examples. Keep in mind, however, that you should not count wages paid to your spouse, parent, children under the age of 21, or any employee under the age of 18.
How to File Schedule H
Schedule H should be filed with Form 1040, 1040-SR, 1040-NR, 1040-SS, or 1041. However, if you are not filing any of these returns, you can file Schedule H alone. To file Schedule H, you’ll need the following information:
You must file Form W-2 for each household employee that you paid $2,600 or more in wages in 2023. The amount increases to $2,700 in 2024. In addition, you’ll need to send Form W-2 with Copy A of Form W-2 to the Social Security Administration (SSA).
Don’t forget to pay federal unemployment tax if you paid $1,000 or more in wages in any calendar quarter in 2022. Each household employee is required to pay 6.2% for social security and 1.45% for Medicare. You, as an employer, hold the responsibility of matching these figures as well as FUTA taxes. This figure varies from 0.6% to 6%. However, the amount can be reduced if you pay state unemployment insurance (SUI or SUTA tax).
Tax Help for Those with Household Employees
There are quite a few responsibilities that come with having household employees. Most important, these can include filing requirements and tax payments that need to be made. It’s important you understand these responsibilities for both your sake and your employee’s. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers.
When it comes to filing taxes as a resident or non-resident alien, the first step is determining your alien status for tax purposes. If you satisfy the requirements of either the IRS green card test or the substantial presence test, you will be considered a resident alien for tax purposes. If you cannot meet the requirements, you will be taxed as a non-resident alien. Here’s how resident and non-resident aliens are taxed and how to make the most out of your situation.
How are resident aliens taxed?
If you’re considered a resident alien, you will be taxed the same way a U.S. citizen would be. In other words, all income must be reported on your tax return. This is even if some of it or all of it was earned abroad. Income can include wages, interest, royalties, dividends, rental income, and other sources. Resident aliens use the same forms and filing statuses as U.S. citizens. Additionally, they have access to the same tax deductions, credits, and exemptions.
How are non-resident aliens taxed?
Non-resident aliens are taxed differently. The IRS only requires non-resident aliens to pay taxes on the income earned in the United States. Similarly, income connected to a U.S. business should be reported. This means any income earned in any foreign country is not taxed by the IRS. Instead of using Form 1040 to file a tax return, non-resident aliens should use Form 1040-NR, U.S. Nonresident Alien Income Tax Return. Non-resident aliens will also qualify for deductions and credits to help reduce their taxable income.
How are dual-status aliens taxed?
If you are a dual-status alien, it means that you were considered a resident alien and a non-resident alien in the same year. This typically occurs the in the year you arrive in the U.S. or depart. In this scenario, you would need to file a tax return. Which one is filed depends on which status you held at the end of the tax year. For example, if you ended the year as a resident alien, you would file Form 1040 and note that it is a dual-status return. You would also need to include a statement of income earned as a non-resident during the tax year. If you choose to use Form 1040-NR as your statement of income, you will need to note that it is a dual-status statement. Dual-status tax returns have several filing restrictions, so consider consulting with a tax professional for help.
Can resident and non-resident aliens leave the U.S. without paying taxes?
In most cases, all aliens leaving the United States will need to secure a sailing permit with the IRS. This document grants IRS clearance and can be obtained by filing Form 1040-C, Departing Alien Income Tax Return or Form 2063, U.S. Departing Alien Income Tax Statement and Annual Certificate of Compliance. You must also pay any tax owed, plus any taxes due from previous years. This process can take 2-3 weeks so you should plan your departure accordingly.
Tax Help for Resident and Non-Resident Aliens
Determining your alien status for tax purposes is only one initial hurdle that you need to overcome when filing a tax return. Filing and paying taxes is a whole other set of tasks and sometimes requires the help of a knowledgeable and experienced tax professional. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers with tough tax situations.
Did you know you are required to pay taxes on your income even if you are not an American citizen? The same is true even if you spend some of your time abroad. One important thing to note, however, is the way you are taxed is determined by your alien status. In other words, resident aliens are taxed differently than non-resident aliens. Here’s an overview of tax tips for resident and non-resident aliens, including how each status affects your taxes.
Resident vs. Non-Resident Alien Status
Before figuring out how you will be taxed, you’ll need to figure out which alien status applies to your situation. The first is the resident alien status. This means you were born outside the United States, do not have U.S. citizenship, but you live in the country. It also means you have satisfied the requirements of one of two IRS tests. These are the green card test or the substantial presence test. The second status is the non-resident alien status. This status is granted to those who do not satisfy the requirements of the green card test or the substantial presence test.
Green Card Test
The green card test is fairly simple. If the U.S. Citizenship and Immigration Service grants you a green card, you satisfy the requirements of this test and are considered a resident alien.
Substantial Presence Test
The substantial presence test is a little more complicated. It is for those who do not have a green card but meet both of the following requirements:
Spent at least 31 days in the United States during the current tax year
Spent at least 183 days in the United States during the last three tax years (including the current tax year)
How to Count Number of Days Present
When counting days, you may count all the days you were in the country in the current year. However, you may only count 1/3 of the days you were present in the year prior to the current year and only 1/6 of the days you were present in the second year prior to the current year. Let’s look at an example. Assume you were present in the country for 120 days in 2023, 180 days in 2022, and 150 days in 2021. Your total number of days present in the U.S. would be 205 days according to the following calculations:
120 days for 2023
60 days for 2022 (1/3 of 180)
25 days for 2021 (1/6 of 150)
This means you’d meet the minimum of 183 days in the United States. Therefore, you’d be considered a resident alien for tax purposes in 2023. However, keep in mind that there are several days that should be excluded from your count, including:
Days you regularly commuted to work in the U.S. from Mexico or Canada
Days you pass through the U.S. for less than 24 hours because you are in transit between two places outside the U.S.
Days you are in the U.S. as a crew member on a foreign vessel
Days you are unable to leave the U.S. due to a medical condition that developed while in the U.S.
Days you are considered an exempt individual
Exempt Individuals
You are considered an exempt individual for a day if you meet any of the following criteria:
You are temporarily in the U.S. as a foreign government-related individual under an “A” or “G” visa, excluding “A-3” and “G-5” class visas
You are a teacher or trainee who is temporarily in the U.S. under a “J” or “Q” visa and comply with the visa requirements
You are a student who is temporarily in the U.S. under an “F,” “J,” “M,” or “Q” visa and comply with the visa requirements
You are a professional athlete who is temporarily in the U.S. to compete in a sporting event for charity
Going back to our previous example, if we were to exclude 30 days that you spent in the U.S. working as a crew member on a foreign vessel in 2023, your new count would be 175. Because the excluded days reduced your count below the 183-day minimum, you would be considered a non-resident alien for tax purposes in 2023.
Tax Help for Resident and Non-Resident Aliens
It’s clear that determining your alien status for tax purposes can get complicated. If you’re still unsure about your status after reading our tax tips for resident and non-resident aliens, you can consult a tax professional for clarification. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers with tough tax situations.
