Taxation of Forgiven Debt - The 1099C & You

Often people fall on hard times and stop paying on credit cards. After a while the account may go to an outside debt collector who might offer a settlement of the debt for 30-40% of the original sum. Once this is paid, the debtor often thinks the matter is closed, but it is not! It is very likely that the creditor will issue a 1099-C. This is a notice to IRS of the forgiven debt. If the debtor does not address this on his return he may get an IRS bill a year or two later with penalties and interest.

A foreclosure on a home may also result in a 1099-C from the mortgage lender if the property is sold for less than the amount of the loan. In this instance, a person loses their home and may also face a tax bill. Usually, the bill comes many months after the tax return was filed as a result of an IRS document matching program. This "under-reporter" notice brings grief to the taxpayer.

The key issue is whether or not the debtor was insolvent. If they were insolvent, it may not be taxable depending on the circumstances. There is an "Insolvency exclusion." You are insolvent when, and to the extent, your liabilities exceed the fair market value of your assets. So it is possible none of your forgiven debt is taxable or it is possible that all or only a portion of it is counted as income.

You may not have any taxable income from the 1099C, but you must account for it on your return. The issue is whether or not you were solvent at the time of the debt cancellation. You only owe tax on the forgiven debt to the extent you were solvent. For instance, if the forgiven debt was $10,000 but you are only worth $5,000; you would only be liable for income tax on that amount. A home foreclosure is complicated and you may have other legal arguments besides insolvency.

There are five situations where a cancelled debt does not have to be reported as income:

Bankruptcy - the debt was already discharged through a bankruptcy proceeding.

Insolvency - your total debts exceed your total assets at the time your debt was settled or deemed non-collectable.

Indebtedness is due to a qualified farm expense.

Indebtedness is due to certain real property business losses.

Discharge of your debt was treated as a gift (You owed Mom $10K and she said "Don't worry honey, consider it a gift").

If you are insolvent you need to explain this to the IRS on your tax return. You can fill out IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness or attach a detailed letter to your tax return explaining the calculation of your total debts and assets.

Do not ignore a 1099-C! Failure to address the 1099C will result in a tax assessment by the IRS for any amount over $600 plus penalty and interest. This will likely occur 12-18 months after you file when IRS matches up the info reported to them with what is on your tax return. Have a tax professional do your return and they can help you determine how much of the 1099-C is taxable.

If you get a letter from IRS on a 1099-C you left off your return, get help ASAP. Otherwise, IRS might file a Federal Tax Lien and take action. Look for a CPA, Enrolled Agent, Accredited Tax Advisor, Accredited Tax Preparer, or Tax Attorney to help you with serious tax issue. You may call the IRS at 1-800-829-1040 for help as well.

Websites you can check out include:

http://www.irs.gov

http://www.naea.org

http://www.nsacct.org

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