1099-C surprise: Canceled debt often taxable as income

For many consumers, after the collector leaves their lives, the taxman arrives

1099-C surprise: Canceled debt often taxable as income


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 4 million taxpayers a year who receive the forms must report that portion of forgiven debt as “income” on their federal income tax returns.

1099-C tax surprise

“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. “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.

Source: IRS Office of Research Publication 6961, 2017 Update

The number of debt cancellation forms sent to taxpayers – and the Internal Revenue Service – shot up after the recession. It fell for the first time in 2016. The IRS estimates 4.0 million 1099-C forms will be filed covering the 2017 tax year, and 4.3 million for 2018. The agency predicts filings will hit 6.3 million in 2025.

Surprise tax problem

The problem: Many consumers have no clue what 1099-C forms are, and some may trash cancellation of debt notices because the forms are sent by the same 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."

“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.”

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, a partner at the Maurice Wutscher law firm in New Jersey who represents debt buyers.

Not all forgiven debt taxable

Consumers who receive the 1099-C cancellation of debt forms should take them to a tax preparer or tax adviser, unless they feel comfortable handling the arcane tax rules and forms on their own. 

“Make sure your tax preparer understands the rules related to these type of activities,” says Mark Steber, chief tax officer for Jackson Hewitt. “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.

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 not be counted as taxable income. “The remaining $3,000 would be reported under other income,” says H&R Block’s Flores.

Debt resolution tax tips

  • 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.

New for the 2017 tax year

Congress has scrambled to extend a tax break for homeowners who were hit by foreclosure or short sale in 2017.

Under the Mortgage Forgiveness Debt Relief Act, mortgage debt that was forgiven for struggling homeowners was excluded from taxes. 

The law expired at the end of 2016, but was extended through tax year 2017 on Feb. 9 – after tax filing season began.  The extension, section 40201 of the Bipartisan Budget Act of 2018, allows you to exclude mortgage debt that was discharged after Dec. 31, 2016.

If you already filed your federal return for 2017, it will be necessary to file an amended return to take advantage of the break, Flores said.

This may be the last year that the break for home debt is available. “Given that Congress has rejected prior attempts to make the exclusion permanent, the likelihood of future extensions is doubtful,” the National Consumer Law Center staff attorney Geoff Walsh wrote in an analysis.

Also for 2017 taxes, the sweeping U.S. tax overhaul enacted at the end of the year provides a break for student loan debt that is erased because of death or disability. Under the plan, the amount forgiven will no longer be subject to taxes. This element of the tax law is set to expire in 2025.  

Fewer 1099-C forms should be issued for debts merely because they have gone 36 months without a repayment, reducing a big headache for taxpayers.

The IRS in November 2016 published a bulletin canceling a previous rule that required creditors to issue 1099-C forms for debts that had gone without a payment for 36 months.

The rule was intended to account for debts that would likely never be repaid. But it resulted in taxes for debts that had not been forgiven at all, and were later the subject of debt collection action.

The 36-month reporting requirement had been cited as a major source of problems for taxpayers by the Taxpayer Advocate Service in its annual report to Congress.

The requirement made it possible for creditors to issue a 1099-C form while continuing to collect a debt, or after selling it to debt buyers. “Creditors may threaten to ‘sic the U.S. government’ on a debtor by issuing  a Form 1099-C as a means of pressuring a debtor to pay,” the advocate’s report said.

Taxpayers who do receive a 1099-C form for a debt that has not been canceled as far as they know should contact the creditor for clarification. If the debt has not in fact been canceled, the creditor should rescind the 1099-C. If the creditor does not rescind the form, it will be necessary to use the IRS dispute process to show that the debt has not been canceled.

"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."

Informing consumers of debt settlement's tax ramifications

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 they settle debts for discounted amounts.

Says Maurice, the debt buyers' attorney, “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 Taxpayer Advocate Service has cited confusion and inadequate communication about 1099-Cs in its annual report to Congress. 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.

The bottom line on 1099-Cs is to be prepared for them. Don’t delay getting help from an expert if you need help determining whether you qualify for one of the exemptions. Ignoring the form can have 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: Threat of tax fraud, tax ID theft grows

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Updated: 12-15-2018