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1099-C surprise: Canceled debt often taxable as income

Summary

Many consumers aren’t aware that forgiven credit card debt may be taxable income, and it shows up on an IRS 1099-C form

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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, something that they must do by Jan. 31. 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.

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.

According to the 2019 update of IRS Office of Research Publication 6961, more than 4.3 million 1099-C forms will be filed covering the 2019 tax year.

That number is projected to rise to more than 4.4 million for the 2020 tax year. The IRS estimates more than 6.5 million filings for the 2025 tax year.

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, but past the point where it would have been paid on time,” said Bruce McClary, vice president of communications 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 2019 tax year

  • Thanks to the federal government’s Further Consolidated Appropriations Act, 2020, which was signed into law on Dec. 20, 2019, taxpayers who’ve had mortgage debt forgiven might not have to pay taxes on it when filing out their 2019 income taxes this year. 
  • That’s because the act extends the Qualified Principal Residence Indebtedness exclusion through the year 2020. This means taxpayers who’ve had up to $2 million in debt forgiven as part of a foreclosure, short sale, deed in lieu of foreclosure or loan modification might not have to pay taxes on it.
  • The new law means this exclusion will apply to mortgage debt forgiven before Jan. 1, 2021. From 2007 through the end of 2017, this exclusion was included as part of the Mortgage Forgiveness Debt Relief Act of 2017. It has now moved to the new law.
  • Say taxpayers who owed $205,000 on their mortgages lost their home to foreclosure and their lender sold it for $200,000. This means their lender forgave these former homeowners $5,000 in debt. Because of the Further Consolidated Appropriations Act, these taxpayers would not have had to pay taxes on that $5,000.

The U.S. Tax Cuts and Jobs Act enacted at the end of 2017 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.

Taxpayers who 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.

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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The editorial content on this page is based solely on the objective assessment of our writers and is not driven by advertising dollars. It has not been provided or commissioned by the credit card issuers. However, we may receive compensation when you click on links to products from our partners.

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