Generally, when a debt is owed and at least $600 of the debt is canceled, forgiven or settled for less than the full amount owed, this amount forgiven is treated for income for tax purposes. Cancelled debts often arise after a home is foreclosed with a deficiency still owed. Cancelled debts also occur when a credit card goes unpaid for the statutory period or the balance is settled for less than the full balance owed. In these common cases, the person receiving the benefit of the debt cancellation may receive a Form 1099-C or 1099-Misc., requiring them to report income and possibly also pay income tax on the amount forgiven/cancelled.
For a more detailed discussion on tax debt and other tax resolution issues, be sure to read Wartchow Law’s Tax Blog.
Cancelled debts are reported on a Form 1099 and not always in the year that the debt is cancelled. Form 1099s can be sent up to three years after the debt was cancelled, which may result in your having to amend that year’s tax returns. Once reported on a 1099, you are required by law to report this income on your tax returns and both the IRS and state includes the amount of cancelled debt as taxable income. Accordingly, this additional taxable income may result in taxes owed at the same rate that income is taxed.
However, there are exceptions to being taxed on cancelled or forgiven debt if you were insolvent immediately before the debt was cancelled or otherwise if you received a discharge in a Chapter 7 or Chapter 13 bankruptcy proceeding. While both insolvency and a discharge in a bankruptcy proceeding may provide an exception for some types of cancelled debts (particularly regarding residential mortgages), insolvency by the IRS standards does not require that you actually file bankruptcy. You can be insolvent according to the IRS without actually filing bankruptcy. If you qualify as “insolvent” according to the IRS standards, you must still report the Form 1099. income on your tax returns however you can separately file Form 982 is you qualify to exclude this income from your taxable income
A common example of cancelled debt is when a credit card balance is settled for less than the full amount owed, thus resulting in an amount which is “forgiven” or cancelled by the credit card company. Under federal law, the credit card company is required to report the amount of the cancelled debt as taxable income to the credit card holder.
As another example, if a personal vehicle was repossessed and then later sold by the lender after repossession, the amount owed on the loan would be reduced by the sale proceeds however usually a “deficiency” is still be owed. In this case, your lender may send you a 1099 for the difference owed which is “cancelled” by them. Unless you file bankruptcy or were insolvent immediately before the cancellation of the deficiency, you may owe income tax on that deficiency.
You should not receive a Form 1099 on debs that were previously discharged in a bankruptcy occurring prior to the issuance of the 1099. In fact, bankruptcy is usually an all-inclusive exclusion from taxes for cancelled debts, however you must still report the 1099 income on Form 982 and attach to your federal tax return. Note that the IRS Form 982 refers to a bankruptcy discharge as a “discharge of indebtedness in a title 11 case” since the Bankruptcy Code is under title 11 of the United States Code.
More information on the taxation of cancelled debts is available at www.IRS.gov and in the IRS Publication 4681.
Located in Edina, Minnesota, attorney Lynn Wartchow represents clients in all Chapters of bankruptcy in Minneapolis, St. Paul, Ramsey and Hennepin County, and throughout Minnesota.