When you have a debt canceled, the IRS considers the canceled debt to be be income for you, taxable just like a paycheck.  There are cases where you don’t have to include all of it though, and mortgage debt forgiven between 2007 and 2012 may be partly excepted from being included as income.

The IRS recently issued their Tax Tip 2012-39, which lists 10 Key Points regarding mortgage debt forgiveness.  Below is the actual text of the Tip.

Mortgage Debt Forgiveness: 10 Key Points

Canceled debt is normally taxable to you, but there are exceptions.  One of those exceptions is available to homeowners whose mortgage debt is partly or entirely forgiven during tax years 2007 through 2012.

The IRS would like you to know these 10 facts about Mortgage Debt Forgiveness:

1. Normally, debt forgiveness results in taxable income.  However, under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude up to $2 million of debt forgiven on your principal residence.

2. The limit is $1 million for a married person filing a separate return.

3. You may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure.

4. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.

5. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.

6. Proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt – do not qualify for the exclusion.

7. If you qualify, claim the special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to your federal income tax return for the tax year in which the qualified debt was forgiven.

8. Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision.  In some cases, however, other tax relief provisions – such as insolvency – may be applicable.  IRS Form 982 provides more details about these provisions.

9. If your debt is reduced or eliminated you normally will receive a year-end statement, Form 1099-C, Cancellation of Debt, from your lender.  By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed.

10. Examine the Form 1099-C carefully.  Notify the lender immediately if any of the information shown is incorrect.  You should pay particular attention to the amount of debt forgiven in Box 2 as well as the value listed for your home in Box 7.

For more information about the Mortgage Forgiveness Debt Relief Act of 2007, visit www.irs.gov. IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments, is also an excellent resource.

You can also use the Interactive Tax Assistant (ITA) available on the IRS website to determine if your canceled debt is taxable.  The ITA tax you through a series of questions and provides you with responses to tax law questions.

You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

For those of you who took advantage of the one-time opportunity in 2010 to convert IRA funds to Roth IRA accounts, spreading the tax over the following two years (2011 and 2012), you are faced with a decision-point:  if you have reason to recharacterize the conversion, you have to do this by October 18, 2011.

Why might you want to recharacterize?

Here’s a ferinstance: If you converted $10,000 from your IRA account on December 31, 2010 into your Roth IRA and invested it in the S&P 500, that $10,000 converted is now worth approximately $8,997 (using a recent price).

If you are in the 25% bracket, you will owe $2,500 on the conversion, which equates to 27.79% in taxes on the conversion.  If your chosen investments did worse than the S&P 500 (and you know some of them probably did), your effective tax will be even higher.

Now, chances are that your investment may increase in value before you actually pay the tax on your 2011 and 2012 returns, but then again maybe it won’t.  Why pay the extra tax (or rather, the tax on the extra amount) if you don’t have to?

You can recharacterize the amount in your Roth IRA that corresponds to this conversion back into your traditional IRA – but you must do it before October 18.  At that time, you’ll also want to file an amended tax return showing that the conversion “did not happen” for tax year 2010.

On the other hand

If you bought the S&P 500 about a year ago with that same $10,000, it’s likely worth about $10,335 today, so you might want to leave the conversion alone.  Now your effective tax rate on the conversion (if you’re in the 25% bracket) is only about 24.19%.  Granted, it’s not a dramatic increase, but still it probably is better than you originally thought when you started this process.  And you’ve got two more years to pay all of the tax.

You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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Social Security taxation: Especially if you had unusual income taxed in 2010, such as a Roth Conversion, you could be subject to as much as 85% taxation of your Social Security benefit.

Alternative Minimum Tax: If you’ve been impacted by this, not only are your ordinary income tax items taxed at a higher rate, but your capital gains and dividends could be taxed at a rate higher than 15% as well.  This happens for folks with incomes between $150,000 and $439,800 (or $112,500 and $302,300 for singles) as the AMT exemption phaseout occurs.

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Child Tax Credit: If your income is over $110,000 ($75,000 if filing Single), the Child Tax Credit reduces by $50 for each $1,000 over that limit.  This has the effect of increasing the marginal tax rate by 5% for each child, as your income increases.

Passive Loss phaseout for rental realty: If your AGI is greater than $100,000, the deduction of up to $25,000 of losses from rental real estate is phased out up to an AGI of $150,000 when the deduction is eliminated altogether.  This can increase the marginal tax rate by 50% ($25,000 credit eliminated as your income increases by $50,000).

There may be other reasons that impact your tax bill, but these are some that have recently come to light as typically occurring.

You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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• New this year! Take a one-time opportunity to reduce your self-employment taxes – In addition to the standard ‘above the line’ deduction described below, self-employed persons can also deduct the cost of their health insurance premiums from their self-employment taxes on Schedule SE. This is a one-time-only opportunity available for 2010 taxes, so if you’re self-employed be sure to take advantage of it.
  

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• Deduct health insurance premiums as a business expense – If you had self-employment income, you may also be able to deduct health insurance premiums you paid for yourself and your dependents as an ‘above the line’ business expense (that is, without itemizing) on your federal tax return.  Be aware, however, that you may not deduct premiums paid for any month in which you were eligible to participate in an employer-sponsored health insurance plan, and that the amount you deduct cannot be greater than your net self-employment income for the year.  Also, keep in mind that you may not be able to include what you paid toward your monthly premiums as an ‘above the line’ expense AND itemize it as described in the next tip. Talk to a tax professional to learn more about the different types of self-employment status and the tax implications of each in your state.
• Itemize your health insurance and medical expenses – Even if you’re not self-employed, if you itemize on your federal tax return you may be able to deduct medical expenses from your taxable income. According to IRS Publication 502, qualifying medical expenses include monthly premiums you pay for coverage (including some Medicare premiums), copayments, deductibles, dental expenses, and costs for some services not covered by your insurance plan. Keep in mind: you can only deduct the portion of your medical expenses that exceeds 7.5% of your adjusted gross income. That means this deduction isn’t for everyone, but if you (or one of your dependents) were seriously ill or hospitalized last year – or if you paid COBRA premiums (without receiving federal subsidy), you may qualify.
• Maximize your refund with your Health Savings Account (HSA) – An HSA is a tax-advantaged savings account used in conjunction with an HSA-eligible health insurance plan. Account contributions, qualified distributions and earnings are all tax-exempt. An HSA allows you to deposit a portion of your pre-tax income into a savings account and use those funds to pay for qualified medical expenses.  Unused money can be invested and accrue from year to year. If you have an HSA, be sure to deduct your contributions up to federally prescribed limits.  Contributions to your HSA designated for 2010 and made before April 18, 2011 can be counted toward your 2010 federal taxes.  According to IRS Publication 969, HSA contributions for the 2010 tax year are capped at $3,050 for individuals and $6,150 for families.
• Be aware of how the COBRA subsidy may alter your taxable income – Persons enrolling in COBRA as the result of a lay-off after June 1, 2010 no longer qualified for the 65% federal COBRA subsidy, but plenty of people who did qualify for the subsidy were still receiving it in 2010.  If you received the COBRA subsidy, your taxable income may increase depending on how much money you made in 2010.  If your adjusted gross income was between $125,000 and $145,000 ($250,000 – $290,000 for those filing joint returns), you may only be eligible to retain a portion of that subsidy. If your adjusted gross income was greater than $145,000 ($290,000 for joint-filers), you are not eligible for the subsidy and should review your tax liability for the subsidy carefully.

Please note that the provisions discussed above may apply differently to you based upon your circumstances, and your local certified public accountant or tax professional will be able to advise you in light of those circumstances.

You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

The QCD provision allows an IRA owner as described to direct a distribution from his IRA to a qualified charitable organization – and this distribution does not impact the IRA owner’s Adjusted Gross Income.  In addition, the distribution can be used to satisfy the IRA owner’s RMD for the year, tax free.

The Problem

The problem that many IRA owners are facing is that the Tax Act was passed so late in the year.  Many IRA owners figured there was no way that this provision could be passed in time to be able to take advantage of it during 2010.  As it turns out, the late passage of the law actually included an extension of the time that an IRA owner had in order to complete the transaction – until the end of January, 2011.

Unfortunately, many IRA owners assumed the worst, and knew that they must complete their minimum distributions before the end of 2010 – so at some point before the law was passed they went ahead and took the RMD.  I call this unfortunate because, having taken the RMD from the account, the IRA owner could no longer utilize the QCD (when it became available again) to satisfy the year’s RMD.

Quite a few people have had this situation to face, often causing them to recognize extra, unplanned income on their income tax returns for 2010.  Even if you sent the money back to the IRA custodian, it was too late.  This is because the IRS considers the first money that you withdraw from your IRA as your RMD for the year – and RMDs are not eligible for rollover (which is what you’d be doing if you sent it back).

You could still have directed a QCD to a charity directly from your IRA and have it treated as tax-free (not included in your AGI, since the Tax Act passed), but you still would have to include your previously-received RMD as income for the year.

A Solution (but it’s too late now)

One way that you could have dealt with this would have been to send a QCD earlier in the year to your charity of choice – and then wait until Congress decided to act.  The risk that you would take in that case is if Congress had not acted, you would still have to include the QCD as income, which could have negative impact on your tax return in general (increasing your AGI, increasing your taxable Social Security benefits, and reducing some deductions, among other things).  But you could still enter the QCD amount as a charitable contribution on your itemized deductions on Schedule A.

As it turns out, taking such an action would have worked in your favor, as the QCD provision was reinstated retroactively for 2010.  But then again, hindsight is perfect, as usual.

You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

1. The Making Work Pay Credit provides a refundable tax credit of up to $400 for individuals and up to $800 for married taxpayers filing joint returns.
2. Most workers received the benefit of the Making Work Pay Credit through larger paychecks, reflecting reduced federal income tax withholding during 2010.
3. Taxpayers who file Form 1040 or 1040A will use Schedule M to figure the Making Work Pay Tax Credit.  Completing Schedule M will help taxpayers determine whether they have already received the full credit in their paycheck or are due more money as a result of the credit.
4. Taxpayers who file Form 1040-EZ should use the worksheet for Line 8 on the back of the 1040-EZ to figure their Making Work Pay Credit.
5. You cannot take the credit if your modified adjusted gross income is $95,000 for individuals or $190,000 if married filing jointly or more, you can be claimed as a dependent on someone else’s return, you do not have a valid Social Security number or if you are a nonresident alien.

Be on the lookout for this important provision as you prepare your return for 2010.

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You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

But what about if you converted funds from two or more IRAs to Roth during 2010… can you have part of the funds taxed in 2010 and part of it taxed during 2011 and 2012?

Unfortunately, you can’t do this.  This goes back to the one very important factor that applies to Roth conversions:  the IRS considers all of your IRAs as one single, aggregated account for purposes of distribution taxability.  Therefore, no matter how many accounts you may have converted from in 2010, all of the distributions must be treated the same way.

Two things allow for some flexibility on this matter though…

1. If you had other distributions in 2010 (besides your conversion), these will certainly be taxed on your 2010 return, and you still can elect to have your conversion funds taxed in 2011 and 2012 if you’d like.
2. If you are married, each of you can choose a different taxation method for your Roth conversion funds, effectively spreading your household taxation over all three years if you like.  Your husband could have his converted funds taxed in 2010 and you could spread the tax on your converted funds over 2011 and 2012, for example.

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You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

Many processors (commercial software) will accept these returns now and send them to the IRS beginning on February 14, so there is no reason to delay.  And if your processor (or tax guy or gal) doesn’t allow for the early acceptance, you can still get your information in to them and they’ll submit it when the time is right.

This delay was explained in the article that I wrote earlier about how some returns would be delayed this year due to the late passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.

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You can pick up my book, An IRA Owner's Manual, in either the print version or the Kindle version by clicking the links.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

Here’s my situation, in 2010, I started with the following:

(A) Rollover IRA (from rollover funds back in 2007 with no new funded added since. $157K was rolled over in 2007, but account is now valued at ~$146K).
(B) Roth IRA (that was opened years ago with minimal amount, but no new funds added in the past decade due to income limitation)
(C) Non-deductible (separate) traditional IRA account opened in 2006 with max allowable IRA amount deposited in each year, but have only been depositing NON-DEDUCTIBLE dollars ($4K each in 2006 & 2007, and $5K each in 2008, 2009, 2010 for a total of $23K invested). However, the account was only worth ~$17K/$18K at the time I went to convert)

In early 2010, after making the 2010 contributions, I converted the entire value of the non-deductible traditional IRA account to a Roth IRA.

My question is: since I’ve kept my non-deductible contributions in a separate account and converted to the Roth IRA, am I subjected to the pro-rata rule for taxes due in 2010 even though I have no other IRA account other than the Rollover IRA? I had thought that since I had a “loss” with my non-deductible account, and that I kept the funds separate, I would not, but not sure.

This was my response:

It seems like this would be pretty complex, but it really isn’t too bad if you keep two things in mind:

1) the IRS looks at all of your traditional IRAs (includes rollovers, deductible contributory and non-deductible contributory) as one single balance

2) given #1, you cannot separate deductible and non-deductible amounts when taking distributions

Since a Roth conversion is a distribution, and knowing what we know from #1 & #2 above, part of your conversion would be taxed and part of it would be tax-free – and the amounts would be pro-rated, based upon a calculation factoring your end-of-year balances in all of your IRA accounts, plus any amount that was distributed during the year.

So, if you take the balance of all of your IRAs at the end of the year ($146k) and add the amount of your distribution for conversion ($18k), you come up with a total of $164k (assuming there were no other distributions in 2010).  Of that, you indicated that there was $23k from non-deductible contributions.  Dividing that non-deducted amount by the total we come up with ~14.02% (23k / 164k = .14024).  Of the $18k that you converted, 14.02% or $2,523.60 would be considered tax-free distribution, and the remaining $15,476.40 would be taxable.  (This calculation was done with the very round figures that you provided.  Actual end-of-year 2010 figures must be used to calculate the true pro-rata amounts.)

The good news is that, if you choose, you can spread the tax on your conversion onto your 2011 and 2012 returns.  Or you can just pay the piper on your 2010 return – it’s your call.

And then there was a follow-up from the reader:

Just a few additional follow-up questions for you:

(1) If only a percentage of my distribution is tax-exempt this year, am I not being “double-taxed” (so-to-speak) on the $15,476.40, since this is after-tax dollars that funded the non-deductible traditional IRA?  If I make NO additional conversions or distribution until I reach of age, 59 1/2 (by the way, I’m currently married and in my mid-forties), what amount is tax-exempt when I make the next distributions?  Can I expect $15,476.40 ($18K – $2,523.60)  + $15,476.40 (taxes due this year) = $30,952.80 now considered as non-deductible because taxes have already been paid (50% was non-deductible conversion, the other 50%, taxes paid in 2010)?  Assuming NO new non-deductible funds moving forward, is my “new” non-deductible amount now stand at $30,952.80?

(2) Since my current Roth IRA is UNDER $30,952.80, how can I now correctly earmarked my Rollover account with taxes already paid to $15K so that when it’s time for me to take distribution from that account, I’m not going to be taxed again (!)?  In other word, for argument sake, let’s just say my Rollover IRA does not grow beyond $146K until I’m 59 1/2, can I then use $15,476.40 as non-deductible dollars of my $146K, thereby, only ~$130K is taxable?  Additionally, I would assume that my Roth would now grow tax-free from here-on-in, so any gains is not subjected to taxes.

(3)  Finally, is there any way that I can undo what was converted to my Roth IRA in 2010 before I file my taxes on April 15?  I did the non-deductible to Roth IRA conversion back in Jan 2010.  I did A LOT of research back in 2009 and there was a lot of advice (Suze Orman, Kiplinger, Money Magazine, etc) that stated that if one had non-deductible funds in a separate traditional IRA, that one would be able to make a Roth conversion in 2010 TAX-FREE.  It was touted as a way for those of us who had not been able to make Roth IRA conversions because of income limits to now be able to take advantage of the Roth.  There was not any mention of the Pro-Rata.  It appears that somewhere in 2010,  the pro-rata rule came into play, and now those conversions are not only NOT tax-free, but potentially can be double-taxed!  I can’t quite understand how this can be done so that I’m not being double-taxed on my non-deductible funds.

… and here is my response to the follow-up:

Back to my #1 and #2 – you had total basis of $23k (the non-deductible amount) in all of your IRAs.  With the distribution and the pro-rata taxation, you will have used up $2,523.60 of the $23k.  As you distribute funds from your IRA, each year the rate will adjust to match the new figures.  YOU MUST KEEP TRACK OF YOUR BASIS ON YOUR OWN – no one else will track this for you, unless you have your tax guy do it and then I’d keep my own record anyhow if I were you.

The amount in your Roth account is not considered non-taxable basis for your Traditional IRA.  The balance of your Roth IRA is classified as:  amounts you’ve contributed, amounts you’ve converted, and growth on the value of the first two amounts.  The only figure that’s important to track is the total of the amount you contributed or converted, since if you begin taking distributions before age 59½ you’ll need to know how much has already been taxed.  Early distributions from the Roth account are not subject to a pro-rata rule – your taxed contributions and conversions come out first, then growth last.

You can re-characterize the Roth conversion at any time before October 15 – but it would be simplest if you did this before April 15.  This will essentially put your money back into the traditional IRA and the IRS treats the situation as if nothing happened.

After my response, the reader replied:

I’ve been researching the re-characterization, but have a couple more questions:

(1) The Roth conversion without income limit, can that be conducted in 2011 and onward, or was this just for 2010 only?

(2) If answer to #1 above is yes, can I roll all the deductible portion, $130K of my Rollover IRA (i.e. $146K – ~$16K = $130K) to my current Employer’s 401K, and then convert the $16K tax-free to my Roth IRA this year since I would have paid taxes on this on 4/15/11?  Tracking the non-deductible versus deductible seems too complicated — can I just do it this way?  That way, outside of the company’s 401K plan, I’d only have a Roth IRA and zero balance in a non-deductible IRA?

To which I responded as follows:

1 – yes, the income limit was eliminated beginning in 2010 and will remain so for the foreseeable future

2 –As I read the code it seems to me that such a move would work.  This would be one way of getting around the problem with your conversion/taxation – re-characterize your conversion from 2010, rollover the monies from the deductible account to your 401(k), and then convert the monies from the non-deducted account to Roth.  The biggest problem with this is getting the 401(k) plan to accept the roll-in of your IRA.

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

I covered Three Reasons You May Not Want to Convert to a Roth IRA in an earlier article, and here we’ll be talking about another – the probability of paying medical expenses from your traditional IRA.

Under current tax law, you are allowed to deduct medical expenses to the extent that the expenses exceed 7.5% of your Adjusted Gross Income (AGI).  In effect, if you utilized IRA distributions to pay for these medical expenses, everything above 7.5% of your AGI can be tax free after deduction.  This is much better than paying up to 35% on a Roth conversion and then using those funds later at no tax.

Since many of us can expect to pay a considerable amount for future medical expenses – whether for doctors and hospitals, or for nursing home costs, or even for in-home nursing care – it might make good sense to maintain a balance in a traditional IRA rather than converting all of it to a Roth IRA.

Either way, since the removal of the income limitation on Roth conversions is not restricted to 2010, you can do a conversion in 2011 or later years with no restrictions (at least under current law).

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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).