1099-C surprise: Canceled debt often taxable as income

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1099-C surprise: Canceled debt often taxable as income


1099-C surprise: Canceled debt often taxable as income



If a debt is forgiven or canceled, the IRS requires lenders to issue a 1099-C tax form to the borrower to show the amount of debt not paid. The IRS then requires the borrower to report that amount on a tax return as income, and it's often an unpleasant surprise:

If you thought your money woes ended last year when you settled that credit card debt, think again.

For many consumers with debt problems, after the debt collector leaves their lives, the taxman arrives.

Months after successfully resolving credit card debts, consumers may receive 1099-C "cancellation of debt" tax notices in the mail. Why? The IRS considers forgiven or canceled debt as income. Creditors and debt collectors that agree to accept at least $600 less than the original balance are required by law to file 1099-C forms with the IRS and to send debtors notices as well. The more than 6 million taxpayers a year who receive the forms must report that portion of forgiven debt as "income" on their federal income tax returns.

"A lot of people don't realize they have any tax issues at all when they are going through this," says Alison Flores, principal tax research analyst at H&R Block, the tax preparation service. "They say 'I'm really poor, I'm broke and I can't pay my bills. How can you consider this income?'"

It is, according to the Internal Revenue Code. For example, a person with $10,000 in credit card debt who negotiates to pay only $6,000 of the balance would have $4,000 in forgiven debt income. That $4,000 must be reported as "other income" on Line 21 of the 1040 tax form. Depending on the amount of debt forgiven, the taxpayer's income level, deductions and other factors, the consumer could face a sizable tax bill come mid-April.

Surprise tax problem
The problem: Many consumers have no clue what the 1099-C forms are, and some may be trashing the cancellation of debt notices because the forms are sent by creditors or debt collectors with whom they thought they no longer had business. Still others are not filing the 1099-Cs with their federal income tax returns -- putting taxpayers at risk for IRS audits, penalties and fines. Consumer credit counselors and tax attorneys say few consumers are aware of the tax implications of settling to pay a lesser amount than they owe in credit card debt.

In some cases it is the IRS that alerts people to the fact that they owe taxes on settled debt ... a very unpleasant surprise.

-- Bruce McClary
National Foundation for Credit Counseling 

"In some cases it is the IRS that alerts people to the fact that they owe taxes on settled debt, but past the point where it would have been paid on time," said Bruce McClary, spokesman for the National Foundation for Credit Counseling, a nationwide group of nonprofit credit counseling agencies. "A very unpleasant surprise for those who are unaware of or don't receive their copy of the 1099-C."

The number of "surprise" tax problems grew as the amount of bad debt shot up during the recession, and has lingered since.

According to the IRS, the number of 1099-C cancellation of debt forms filed with the federal government by creditors and debt collectors has seen a massive increase, including a huge surge after the recession. The IRS received fewer than 1 million forms in the calendar year 2003 and 5.98 million in 2014. The projected number for 2015 is 6.5 million, and the IRS expects to get 8 million debt forgiveness forms in 2023.

IRS 1099-C tax form filings

The number of debt cancellation forms sent to taxpayers -- and the Internal Revenue Service -- shot up after the recession and is expected to keep climbing. The IRS says nearly 6 million 1099-C forms were filed in the 2014 tax year, and projects 6.4 million in the 2015 tax year. The agency predicts filings will hit 8 million in 2023.

Source: IRS Office of Research Publication 6961, September 2015 Update

Negotiating with creditors, debt collectors and debt buyers to pay a fraction of the amount owed is a common practice in the industry, often accomplished through third-party agents such as consumer credit counselors or debt settlement specialists.

"Debt buyers are willing to negotiate a discount, sometimes, depending on a person's circumstances, at a very significant discount off the entire balance, to settle the debt," says Donald Maurice, legal counsel for the 600-member DBA International, a trade group of companies that buy and sell portfolios of debt from banks and other creditors.

Not all forgiven debt taxable
Consumers who receive the 1099-C cancellation of debt forms should immediately take them to a tax preparer or tax adviser, experts say.

"Make sure your tax preparer understands the rules related to these type of activities," says Mark Steber, chief tax officer for Jackson Hewitt tax preparation service. "Ask to talk to an office manager. Tell them 'I need to see someone who understands this type of situation.'"

Taxpayers may qualify for one of several exclusions that allow them to reduce taxable income from canceled debts. If the exclusions apply, they must file an IRS form 982 in addition to the 1099-C.

"Theoretically, you have [taxable] income if you don't meet one of the exceptions," says Connecticut tax attorney Eric L. Green.

The 6 exceptions to paying tax on forgiven debt include debts discharged during bankruptcy and debts of consumers who are insolvent (meaning their liabilities exceed their assets) before the cancellation of debt. However, the exclusion applies only up to the amount by which consumers are insolvent. That means if $5,000 in debts were forgiven and liabilities exceeded assets by $2,000, then the $2,000 would be not be counted as taxable income. "The remaining $3,000 would be reported under other income," says H&R Block's Flores.

New in tax year 2015 is an exclusion for students of Corinthian College who had their student loans wiped out in a regulatory action. In February 2015, federal regulators announced $480 million in debt forgiveness for Corinthian studens lured into costly loans by false promises of jobs. However, the method for claiming the exclusion is not clear yet, Flores said, as the IRS 982 form does not include a line for it. "I'd wait to file, and definitely ask a tax professional about it," she said.


  • Consult a tax adviser before finalizing a debt settlement, and ask for a tax preparer who is knowledgeable about 1099-Cs.
  • Clarify with the creditor or debt collector the exact amount that will be declared on the 1099-C form.
  • Be aware that the 1099-C is coming. Don't throw it away. Take it to your tax preparer.
  • If there is a dispute about the amount reported on the form, contact the creditor or debt collector immediately to resolve the matter. Ask for a corrected 1099-C form.

Homeowners exclusion extended

Homeowners who default on mortgage loans on their primary residences may also qualify for an exclusion from income on foreclosures under the Mortgage Forgiveness Debt Relief Act, which took effect in 2007 to help homeowners caught in the mortgage crisis. This provision applies to up to $2 million in mortgage debt forgiven in calendar years 2007 through 2016. The exception had been scheduled to expire, but was extended by Congress.

Steven M. Piascik, a certified public accountant and president of Piascik & Associates in Richmond, Virginia, warns, "If you use the proceeds from a home equity line of credit to pay off credit card debts, or for something other than making improvements to your home, that portion will not qualify for the $2 million exception."

However, if you used a credit card to pay for home improvements on your primary residence and can prove that the charges were exclusively for home improvements, you may be able to claim an exemption from mortgage-related debt forgiveness income for that card debt.

Informing consumers
Much of the surprise element of the 1099-C cancellation of debt forms could be eliminated, say tax preparers, if all creditors and debt buyers routinely informed consumers that there could be tax ramifications when settling debts for discounted amounts.

"The bank doesn't tell you," says Green, the Connecticut tax attorney. "From the bank's perspective, it's not their job to give tax advice."

Be aware and prepare for it. When you receive that form, go immediately to a tax adviser. Don't ignore it. That has real dollars and cents consequences.

--  Eric L. Green 
Tax attorney 

Says Maurice from the debt buyers group: "There is no current law that says that a debt buyer must disclose that a 1099-C would be forthcoming after the settlement of debt."

The National Taxpayer Advocate Service has cited confusion and inadequate communication about 1099-Cs in its annual report to Congress on IRS improvements needed to help consumers. The taxpayer advocate's office has published YouTube videos in an effort to demystify the 982 tax form needed to claim an exemption from taxes on forgiven debt.

Another potential problem: receiving a 1099-C before the debt is actually paid off. According to Lauren Saunders, managing attorney for the National Consumer Law Center, creditors have sent cancellation of debt forms to consumers at the point that the credit card issuers charged off the debt and sold it to debt buyers. "The consumer is potentially liable both for taxes on supposedly forgiven debt while continuing to be liable for the debt," Saunders says. "We've had calls about that situation. Seems like you can't have it both ways: Either you forgive it or sell it but not both."

A consumer in this situation should contact  the creditor who filed the 1099-C for clarification, said Flores of H&R Block. You can also check your credit report to see if the debt is still marked as outstanding -- but don't expect that to carry much weight with the tax collector.  "The IRS works with data matching -- if they get a copy of a 1099-C, they'll look for that (income) on the tax return," she said. "As far as the IRS is concerned, that is what they know." If the creditor does not rescind the 1099-C, it will be necessary to use the IRS dispute process to show that the debt has not been canceled.

The federal taxpayer advocacy agency cited the gap in creditor reporting requirements as one of the most serious IRS consumer problems in its 2010 report to Congress. "A creditor that issues a Form 1099-C is not necessarily canceling a debt, yet the IRS assumes that Form 1099-C reflects taxable income to the debtor," according to the report. The taxpayer advocate recommended that the IRS revise the 1099-C form to include a box for creditors to indicate whether a debt was actually canceled. The IRS responded that it would consult its legal advisers, but forms have yet to change. 

'Be aware of it and prepare for it'
The bottom line on 1099-Cs, says tax attorney Green: "Be aware and prepare for it. When you receive that form, go immediately to a tax adviser. Don't ignore it. That has real dollars and cents consequences."

Steber, from Jackson Hewitt, warns that the IRS is more advanced at tracking taxpayers' income. "There is an increased likelihood that if you had one of these events that the IRS knows about it," he says. "The IRS tracks it back. The IRS is quick to catch up with the person who, for whatever reason, left that [1099-C] off of their return."

Taxpayers who might have moved and didn't receive their 1099-C notices in the mail from creditors can't count on ignorance as a defense: "They will catch up with you," Steber says.

See related: Beware growing tax fraud threat, Canceled debt exemption little usedCanceled debt tax notices riddled with problems

Updated: January 22, 2016


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Updated: 01-21-2017


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