Debt and Income Taxes

Have you been having trouble paying your debts? Have you settled any of your debts for less than what was owed? or maybe you've given up on paying some of your debts. You might be in for a nasty surprise this tax season: Form 1099-C.

Form 1099-C or "Cancellation of Debt" is sent to individuals who were insolvent and had all of their debts (or even a portion) of their debts written off or cancelled by their creditor. It's a creditor's final slap in the face. The IRS may require you to report as income any amounts reported on Form 1099-C even though you didn't receive any money. For the IRS a cancellation of a debt is considered a personal net gain and as such considerable taxable.

So what do you do if you get this form in the mail? Well, you must report the amount on Box 2 as income on your tax return. Unless any of the following situations apply to you:

1. Bankruptcy – the debt was already discharged through a bankruptcy proceeding.


2. Insolvency – your total debts exceed your total assets at the time your debt was settled or deemed non-collectable. You can let the IRS know about your insolvency by a) By filling out IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness or b) attaching a detailed letter to your tax return explaining the calculation of your total debts and assets. You are insolvent if your debt total is greater than your total assets.


3. Indebtedness is due to a qualified farm expense.


4. Indebtedness is due to certain real property business losses.


5. Discharge of your debt was treated as a gift. (that's one nice creditor you had)

You can't claim to the IRS that you never received a 1099-c. Even if you didn't, you are expected to recognize a capital gain if you settle your debts for less than what was owed or any amounts written off. If the name of the creditor doesn't sound familiar then the creditor may have sold the debt to a collection agency or maybe the name of the parent company is what's listed on the form.

For others still struggling with debt consider this:

1. If you are thinking of contacting your debtors and asking for a settlement amount, make sure to ask them if they intend to submit a 1099-C form to the IRS before you agree on a settlement.


2. If so, rethink your decision to settle your debts. Maybe paying your debts in full is in your best interest.

Finally, a recent exception to this rule was put in place recently when the Mortgage Forgiveness Debt Relief Act was signed into law at the end of 2007. This Act amends the Internal Revenue Code to exclude from gross income amounts attributed to a discharge of indebtedness incurred to acquire a principle residence. So, if you have bought a home you can no longer afford, and it is foreclosed on or a short sale takes place you will no longer be issued a 1099-C for the amount the sale fell short of the loan amount. But this is only if this home was where you lived. This act doesn't provide relief for investment properties, second homes, etc. The amount of debt forgiveness can be up to $2 Million.

Now for my disclaimer: Unfortunately, it is impossible to give comprehensive tax advice over the Internet, no matter how well researched or written. Before relying on any information given on this site, contact a tax professional to discuss your particular situation.