Did you know that the Internal Revenue Service considers forgiven debt a source of income, and have to pay taxes on that “income.” And if you’ve ever settled a debt for less or had debt forgiven entirely, you probably got a surprise in the mail come tax season: the dreaded Form 1099-C. Form 1099-C is the form you file to report debt-related income.
If you got a 1099-C in the mail, don’t despair. A few exclusions apply, and you may be able to avoid paying taxes on canceled debt. The big exception is bankruptcy. But don’t rush to file for bankruptcy just yet. If debts were canceled before you apply for bankruptcy, those debts won’t likely keep you from paying taxes on them. Plus, bankruptcy crushes your credit. Other exclusions include:
- Cancellation of certain student loans
- Amounts specifically excluded from income by law like gifts or bequests
- Debts canceled due to insolvency
Let’s look more at these and other exclusions, and what to do if you think you qualify for one.
What Is a 1099-C?
A 1099-C reports Cancellation of Debt Income (CODI) to the IRS. According to the IRS, if a debt is canceled, forgiven or discharged, you must include the canceled amount in your gross income and pay taxes on that “income,” unless you qualify for an exclusion or exception. Creditors who forgive $600 or more of debt for you are required to file Form 1099-C with the IRS. Find some tips for negotiating with creditors.
The Form 1099-C is more common than you might think. According to the IRS’s Office of Research Publication 6961, it received almost 4.0 million 1099-Cs in 2017. It projects more than 4.2 million people will receive 1099-Cs in 2018.1 And estimates for 2019 are 4.5 million.1
What Should I Do if I Get a 1099-C?
The first step is if you’ve received one, don’t ignore it. The IRS is looking to have that income included in the tax return, unless there is an exception or exclusion.”
Steven J. Elliott, CPA, MST, Tax Director for Schwartz and Company, LLC, said it well, “Even if you don’t get a Form 1099-C from a creditor, the creditor may very well have submitted one to the IRS. If you haven’t listed the income on your tax return and the creditor has provided the information to the IRS, you could get a tax bill or worse, an audit notice. This could end up costing you more in IRS interest and penalties in the long run.”
The second step is to figure out if you qualify for an exclusion or exception. If you don’t get it right—or ignore it altogether—you’ll pay more in taxes than you have to. Figuring out how much you have to pay can be complicated. So if you’re accustomed to doing your own taxes, this is a situation where it can really pay to get expert advice from a tax professional. A tax professional can help you determine whether you can reduce the amount of canceled debt you have to pay taxes on or skip paying taxes on it altogether as a result of one of the following exceptions or exclusions.
Canceled debts that are considered income, but that can be excluded from your taxable income are called “exceptions to cancellations of debt income” and include:
- Amounts specifically excluded from income by law, such as gifts, inheritances or bequests
- Cancellation of certain qualified student loan debt
- Canceled debt that if paid by a cash basis taxpayer is otherwise deductible
- A qualified purchase price reduction given by a seller
- Pay-for-Performance Success Payments that lower the principal on your home mortgage under the Home Affordable Modification Program
Canceled debts that can be excluded from income and that you don’t have to pay taxes on, at least partially, are called “exclusions to cancellations of debt income” and include:
- Cancellation of qualified principal residence indebtedness that happens before January 1, 2018
- Debt canceled in a Title 11 bankruptcy
- Debt canceled due to insolvency (not being able to pay your debts)
- Cancellation of qualified farm indebtedness
- Cancellation of qualified real property business indebtedness
Caution: You can only use the exclusions—the second list—after you apply the exceptions. And, if you use the exclusions, you likely have to do some fancy tax footwork know as reducing your tax attributes—covered below. Sound confusing? It can be, which is why a tax professional can be very useful in navigating the legalese of what debt is and isn’t excludable from taxable income. For full details see IRS Publication 4681 (2018), Canceled Debts, Foreclosures, Repossessions, and Abandonments.
My Debt Qualifies for a 1099-C Exception? How Do I Get One?
If you qualify for an exclusion, you have to complete and submit Form 982 to reduce your tax attributes. It may not be easy. The title of the form alone, “Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment,” is intimidating. To help you get started, let’s take a look at two of the most common exclusions that apply.
1. Debt Canceled in a Title 11 Bankruptcy Case
You don’t have to pay tax on debt successfully discharged in bankruptcy. Title 11 refers to the section of U.S. Code that’s referred to as the Bankruptcy Code. This doesn’t mean only debts wiped out in a Chapter 11 bankruptcy qualify for this exclusion.
However, if you settled a debt before you filed for bankruptcy, the creditor may still send you a 1099-C indicating the forgiven amount. And you’ll have to research whether there are other exceptions or exclusions you can use to avoid paying taxes on that amount.
“We are seeing where some taxpayers have received 1099-Cs and they subsequently filed for bankruptcy,” Karla Dennis, Enrolled Agent and CEO of Cohesive Tax, said. “Only debts discharged in bankruptcy are covered [by the bankruptcy exclusion]. If you settled a debt in January and filed bankruptcy later in the year, chances are you probably were insolvent in January but that’s a separate calculation that needs to be done.”
2. Debt Canceled Due to Insolvency
Along with bankruptcy, insolvency is one of the most common exclusions taxpayers use to avoid paying taxes on canceled debt.
Here’s how it works. You make a list of the value of all your assets and a list of all the debts you owe, including debts that may not be dischargeable in bankruptcy, such as student loans. You’re insolvent to the extent that your liabilities (debts) exceed your assets. Here are a couple of examples.
Example 1: Your assets are worth $35,000 and your debts total $45,000, so you’re insolvent to the tune of $10,000. You settle a debt with a creditor who agrees to forgive $8,500. You don’t have to report any of that money as income on your tax return.
Example 2: Your assets are worth $35,000 and your debts still total $45,000, but the creditor writes off a $14,000 debt. You don’t have to report $10,000 of the income, but you will have to report $4,000 as income on your tax return. And you have to fill out Form 982 to demonstrate to the IRS why you aren’t including the amount listed on the 1099-C in your taxable income.
“Timing is everything,” William J. Purdy, III, an attorney with a Master’s degree in taxation who practices in the Law Office of Simmons & Purdy in California, said. “Take a look at your finances right before the debts were forgiven. Include student loans, debts to family members, everything that you owe everyone on the planet. List every single debt you have (on Form 982). On the other side, you list the Fair Market Value of everything you have. For millions of people, their debts exceed the value of everything they have.”
What Can I Do if I Paid Taxes on a Debt That Was Excluded?
All three advisers explained that taxpayers who erroneously pay taxes on forgiven debt can go back and amend prior year’s tax returns—for up to three years—and could get a refund for those years.
To amend a previous tax return, collect all the documents you need including the original tax return you filed. Then, download all the necessary forms you need. Tax Form 1040X can be used to adjust income and amend a previous return. Make sure that this adjustment compensates for the amount of your forgiven debt. If you’re claiming any exclusions when you refile, explain why. You can’t e-file amended tax returns, so you’ll need to mail your completed paperwork directly to the IRS.
If you’re worried about how debt or other financial issues are impacting your credit, you can check your credit using Credit.com’s free Experian credit score and credit report card. This free tool breaks your credit score down into sections and gives you a grade for each. You see how your payment history, debt and other factors affect your score and get recommendations for steps you to consider to improve specific areas. And checking your credit report card and score on Credit.com doesn’t affect your credit in any way.
If you have tax questions, the Tax Learning Center.
This article was originally published April 20, 2011, and has been since been updated by another author.