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Over the years I have received many calls from surprised taxpayers that their debts written off, whether it be from home loan or credit card debt, created income that needed to be reported on the tax returns as taxable income. The basic theory for all taxation, is that if you are wealthier,  then there is a good chance you need to pay taxes on that wealth.

a5-300x150When a person borrows money and buys an asset (for a car or home, for example), they typically do not think if they do not repay that loan that it creates income, but under the tax rules it may. As an example, say you borrow $20,000 from the bank and buy a car. You run into bad luck,  stop paying the loan, and the car loan defaults and they take the car. After selling the cat, say you still owe $5000 on the loan after the car is sold. If they write-off the $5,000 it can create income since you received $20,000 and paid back $15,000, so you are $5,000 richer and that $5,000 of wealth is subject to tax. The tax form that you would receive in these cases is a form 1099-C, Cancellation of debt.

There are a few exceptions to this rule, for instance, if you are in bankruptcy or insolvent (assets less than liabilities) when the debt is written off. If either of these exceptions are your case, then the write-off of the tax debt would not be taxable. The lender also needs to be a commercial lender and not a family member or friend. If you fail to pay the family member or friend, then the write-off would be viewed as a gift from them to you. The other main exception is if you merely guarantee  debt, by co-signing, then if the main borrow defaults typically you did not become wealthier and you would not have to pay tax on that transaction. The last major exception is if under the terms of the loan, the only recourse of the lender has is to take back the property to satisfy the debt. They call this non-recourse debt, and a write down of non recourse debt is typically not taxable.

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Both the Internal Revenue Service and New York State take the evasion of paying taxesseriously and will conduct a criminal investigation if they believe that you are doing so. If either or both agencies are able to prove that you purposely did not pay taxes, you will face monetary penalties, as well as the possibility of prison.

You may be found guilty of committing tax fraud if you intentionally avoid paying tax by:

  • Under-reporting taxable income
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