Month: October 2015

Lending money to a cash-strapped friend or family member is a noble and generous offer that just might make a difference. But before you hand over the cash, you need to plan ahead to avoid tax complications down the road.

Let’s say you decide to loan $5,000 to your daughter who’s been out of work for over a year and is having difficulty keeping up with the mortgage payments on her condo. While you may be tempted to charge an interest rate of zero percent, you should resist the temptation. Here’s why.

When you make an interest-free loan to someone, you will be subject to “below-market interest rules.” IRS rules state that you need to calculate imaginary interest payments from the borrower. These imaginary interest payments are then payable to you and you will need to pay taxes on these interest payments when you file a tax return. Further, if the imaginary interest payments exceed $14,000 for the year, there may be adverse gift and estate tax consequences.

Exception: The IRS lets you ignore the rules for small loans ($10,000 or less), as long as the aggregate loan amounts to a single borrower are less than $10,000 and the borrower doesn’t use the loan proceeds to buy or carry income-producing assets.

In addition, if you don’t charge any interest, or charge interest that is below market rate (more on this below), then the IRS might consider your loan a gift, especially if there is no formal documentation (i.e. written agreement with payment schedule) and you go to make a nonbusiness bad debt deduction if the borrower defaults on the loan–or the IRS decides to audit you and decides your loan is really a gift.

Formal documentation generally refers to a written promissory note that includes the interest rate, a repayment schedule showing dates and amounts for all principal and interest, and security or collateral for the loan, such as a residence (see below). Make sure that all parties sign the note so that it’s legally binding.

As long as you charge an interest rate that is at least equal to the applicable federal rate (AFR) approved by the Internal Revenue Service, you can avoid tax complications and unfavorable tax consequences.

AFRs for term loans, that is, loans with a defined repayment schedule, are updated monthly by the IRS and published in the IRS Bulletin. AFRs are based on the bond market, which changes frequently. For term loans, use the AFR published in the same month that you make the loan. The AFR is a fixed rate for the duration of the loan.

Any interest income that you make from the term loan is included on your Form 1040. In general, the borrower, who in this example is your daughter, cannot deduct interest paid, but there is one exception: if the loan is secured by her home, then the interest can be deducted as qualified residence interest–as long as the promissory note for the loan was secured by the residence.

If you have any questions about the tax implications of loaning a friend or family member money, don’t hesitate to call.

• By Leon Clinton
• October 12, 2015

Generally, debt that is forgiven or canceled by a lender is considered taxable income by the IRS and must be included as income on your tax return. Examples include a debt for which you are personally liable such as mortgage debt, credit card debt, and in some instances, student loan debt.

When that debt is forgiven, negotiated down (when you pay less than you owe), or canceled you will receive Form 1099-C, Cancellation of Debt,from your financial institution or credit union. Form 1099-C shows the amount of canceled or forgiven debt that was reported to the IRS. If you and another person were jointly and severally liable for a canceled debt, each of you may get a Form 1099-C showing the entire amount of the canceled debt. Give the office a call if you have any questions regarding joint liability of canceled debt.

Creditors who forgive $600 or more of debt are required to issue this form. If you receive a Form 1099-C and the information is incorrect, contact the lender to make corrections.

If you receive a Form 1099-C, don’t ignore it. You may not have to report that entire amount shown on Form 1099-C as income. The amount, if any, you must report depends on all the facts and circumstances. Generally, however, unless you meet one of the exceptions or exclusions discussed below, you must report any taxable canceled debt reported on Form 1099-C as ordinary income on:

• Form 1040 or Form 1040NR, if the debt is a nonbusiness debt;
• Schedule C or Schedule C-EZ (Form 1040), if the debt is related to a nonfarm sole proprietorship;
• Schedule E (Form 1040), if the debt is related to non-farm rental of real property;
• Form 4835, if the debt is related to a farm rental activity for which you use Form 4835 to report farm rental income based on crops or livestock produced by a tenant; or
• Schedule F (Form 1040), if the debt is farm debt and you are a farmer.

Exceptions and Exclusions

If you’ve had debt forgiven or canceled this year and receive a Form 1099-C, you might qualify for an exception or exclusion. If your canceled debt meets the requirements for an exception or exclusion, then you don’t need to report your canceled debt on your tax return. Under the federal tax code, there are five exceptions and four exclusions for tax year 2015. Here are the five most commonly used:

Note: The Mortgage Debt Relief Act of 2007, which applied to debt forgiven in calendar years 2007 through 2014, allowed taxpayers to exclude income from the discharge of debt on their principal residence. Up to $2 million of forgiven debt was eligible for this exclusion ($1 million if married filing separately) and debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, also qualified for the relief. As of this writing, Congress has yet to reauthorize the Act for calendar year 2015.

1. Amounts specifically excluded from income by law such as gifts, bequests, devises or inheritances

In most cases, you do not have income from canceled debt if the debt is canceled as a gift, bequest, devise, or inheritance. For example, if an acquaintance or family member loaned you money (and for whom you signed a promissory note) died and relieved you of the obligation to pay back the loan in his or her will, this exception would apply.

2. Cancellation of certain qualified student loans

Certain student loans provide that all or part of the debt incurred to attend a qualified educational institution will be canceled if the person who received the loan works for a certain period of time in certain professions for any of a broad class of employers. If your student loan is canceled as the result of this type of provision, the cancellation of this debt is not included in your gross income.

3. Canceled debt, that if it were paid by a cash basis taxpayer, would be deductible

If you use the cash method of accounting, then you do not realize income from the cancellation of debt if the payment of the debt would have been a deductible expense.

For example, in 2014, you obtain accounting services for your farm using credit. In 2015, due to financial troubles you are not able to pay off your farm debts and your accountant forgives a portion of the amount you owe for her services. If you use the cash method of accounting you do not include the canceled debt as income on your tax return because payment of the debt would have been deductible as a business expense.

4. Debt canceled in a Title 11 bankruptcy case

Debt canceled in a Title 11 bankruptcy case is not included in your income.

5. Debt canceled during insolvency

Do not include a canceled debt as income if you were insolvent immediately before the cancellation. In the eyes of the IRS, you would be considered insolvent if the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation.

For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account).

Here’s an example. Let’s say you owe $25,000 in credit card debt, which you are able to negotiate down to $5,000. You have no other debts and your assets are worth $15,000. Your canceled debt is $20,000. Your insolvency amount is $5,000. Because you are insolvent at the time of the cancellation, you are only required to report the $15,000 on your tax return.

If you exclude canceled debt from income under one of the exclusions listed above, you must reduce certain tax attributes (certain credits, losses, basis of assets, etc.), within limits, by the amount excluded. If this is the case, then you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to report the amount qualifying for exclusion and any corresponding reduction of those tax attributes.

Exceptions do not require you to reduce your tax attributes.

Questions?

Don’t hesitate to call if you have any questions about whether you qualify for debt cancellation relief.

• By Leon Clinton
• October 9, 2015

In most cases, gains from sales are taxable. But did you know that if you sell your home, you may not have to pay taxes? Here are ten facts to keep in mind if you sell your home this year.

1. Exclusion of Gain. You may be able to exclude part or all of the gain from the sale of your home. This rule may apply if you meet the eligibility test. Parts of the test involve your ownership and use of the home. You must have owned and used it as your main home for at least two out of the five years before the date of sale.

2. Exceptions May Apply. There are exceptions to the ownership, use, and other rules. One exception applies to persons with a disability. Another applies to certain members of the military. That rule includes certain government and Peace Corps workers. For more information about these exceptions, please call the office.

3. Exclusion Limit. The most gain you can exclude from tax is $250,000. This limit is $500,000 for joint returns. The Net Investment Income Tax will not apply to the excluded gain.

4. May Not Need to Report Sale. If the gain is not taxable, you may not need to report the sale to the IRS on your tax return.

5. When You Must Report the Sale. You must report the sale on your tax return if you can’t exclude all or part of the gain. You must report the sale if you choose not to claim the exclusion. That’s also true if you get Form 1099-S, Proceeds From Real Estate Transactions. If you report the sale, take a look at the Questions and Answers on the Net Investment Income Tax on IRS.gov or call the office.

6. Exclusion Frequency Limit. Generally, you may exclude the gain from the sale of your main home only once every two years. Some exceptions may apply to this rule.

7. Only a Main Home Qualifies. If you own more than one home, you may only exclude the gain on the sale of your main home. Your main home usually is the home that you live in most of the time.

8. First-time Homebuyer Credit. If you claimed the first-time homebuyer credit when you bought the home, special rules apply to the sale. For more on those rules, please call.

9. Home Sold at a Loss. If you sell your main home at a loss, you can’t deduct the loss on your tax return.

10. Report Your Address Change. After you sell your home and move, update your address with the IRS. To do this, file Form 8822, Change of Address. You can find the address to send it to in the form’s instructions on page two. If you purchase health insurance through the Health Insurance Marketplace, you should also notify the Marketplace when you move out of the area covered by your current Marketplace plan.

Questions? Help is just a phone call away.

• By Leon Clinton
• October 6, 2015