taxesphantomdebtWhen your debt is cancelled or “forgiven” by a creditor, you may owe taxes on that debt. This debt is called phantom income, named so because despite the fact that the IRS considers it income, it never appears in your bank account.

Imagine losing the home of your dreams, either through a short sale or foreclosure, and then receiving tax forms indicating you owe taxes on the cancelled or “forgiven” debt. This debt is known as phantom income—named because it never appears in your bank account despite being considered income—and it can often be enough to make anyone panic.

In the case of a short sale or foreclosure where debt is typically forgiven and phantom income comes into play, you may receive two forms: a 1099-A and a 1099-C.

Form 1099-A, Acquisition or Abandonment of Secured Property, is informational. It explains when the lender took the property back or considered it abandoned, how much you owed on the property, and the property’s fair market value.
Form 1099-C, Cancellation of Debt, is the form that often really worries people. This form implies that you have to include the cancelled mortgage debt in your gross income and pay taxes on the forgiven debt—the last thing you need if you’re facing tough financial times.

Here are some things you may want to be familiar with if you find yourself in this situation:

1. The Mortgage Forgiveness Debt Relief Act. This act allows consumers to exclude from income any forgiven debt related to a primary residence. In other words, if the forgiven debt was the original loan on a home or a loan used to repair or remodel a home, a person wouldn’t owe any taxes. Originally set to expire at the end of 2013, Congress voted at the last minute to extend this act for 2014, meaning that debt cancelled in 2014 falls under this rule as outlined in IRS Publication 4681.

2. Insolvency. Another situation where taxpayers may not have to pay taxes on forgiven debt is during insolvency, which happens when someone is unable to pay his or her debts. An insolvency exception can apply to consumer debts besides mortgages, such as cancelled credit cards and loans. (Use the IRS insolvency worksheet to figure out if you qualify.)

There may be other instances where you don’t actually owe taxes on phantom income, such as if you own a business as a partnership and the losses you deduct offset your phantom income. There are also other sources of phantom income that may arise—such as the depreciation recapture when you sell a business asset—and in some cases, you will in fact owe taxes on income you never received.

If you do find yourself dealing with phantom income and you have questions or concerns, consult a reputable tax or finance professional who can review your tax return.

Eva Rosenberg, EA, is the publisher of TaxMama.com®, where your tax questions are answered. She teaches tax professionals how to represent you when you have tax problems. She is the author of several books and e-books, including Small Business Taxes Made Easy. Follow her on Twitter: @TaxMama