For many people, one lost job, unexpected medical procedure, illness, or other unanticipated life event can lead to financial demise, forcing them to file bankruptcy or enter into a debt settlement agreement. Initially, this can be a huge relief for people who were drowning in debt with no way to pay. However, what many people fail to realize (and plan ahead for) is the fact that their debt that is canceled, forgiven, or discharged may become taxable income.
In most situations, if you receive a Form 1099-C from a lender, you will have to report the amount on that form to the Internal Revenue Service as taxable income. Certain exceptions do apply which we share below. Common examples of when you might receive a Form 1099-C include:
- Return of property to a lender
- A short sale of real estate; or
- A loan modification with principal forgiveness
If you are hoping that there may be a way for you to avoid this, here are the six exceptions that may apply to your situation:
#1: DEBTS CANCELLED WHEN YOU WERE INSOLVENT
This exception often surprises people - Aren’t most debts forgiven because people do not have the money to pay them off? That’s true which is why it’s important to note that this exclusion applies only up to the amount by which you are insolvent.
Here’s an example: Manuel owed $60,000 in credit card debt, which he settled by paying $5,000. He received a Form 1099-C showing canceled debt income of $55,000 ($60,000 minus $5,000). He had no other debts. His assets at the time were worth $3,000.
- Canceled debt: $55,000
- Total assets: $3,000
- Insolvency amount: $52,000
- Manuel reports $3,000 ($55,000 minus the $52,000 insolvency amount) as income on his tax return.
#2: DEBTS DISCHARGED IN BANKRUPTCY
This one is straight-forward: If you filed bankruptcy and receive a discharge, you do not report the discharged debt as canceled debt income. Once a debt is discharged, you legally do not owe it, and there is no debt which is cancelled by the creditor.
#3: STUDENT LOANS FORGIVEN AFTER YOU'VE WORKED A CERTAIN PERIOD OF TIME
If your student loans contain a loan forgiveness provision based on service in your field of work, you should not include the canceled debt as income.
#4: FORGIVEN INTEREST THAT WOULD HAVE BEEN DEDUCTIBLE (SUCH AS INTEREST ON BUSINESS DEBT)
You do not have to pay tax on the portion of the debt due to interest, if you could have deducted the interest if you had paid it. On the other hand, if you could not have deducted it – for example, if it was interest on a personal credit card – you must pay taxes on all the forgiven debt, including the interest.
#5: CANCELLATION OF DEBT AS A GIFT
- Generally, the IRS will believe you if you say it is a gift and it's between parties such as family members or friends.
- The IRS takes a dim view of taxpayers claiming that canceled debt from banks, employers or anyone else with whom you have a strictly working relationship are "gifts."
- Note: If more than $13,000 of debt is canceled in one year, the gift giver has to file a gift tax return (although they almost certainly will not owe a tax). That should not affect you as the recipient.
#6: BUSINESS AND FARM EXCLUSIONS
You may not have to pay tax on canceled debt if it was in connection with your farm, or if the debts were attached to business real estate and were forgiven when you owed more than the property was worth.
THINGS TO KNOW
If you received a 1099-C form and you qualify for one of these exceptions, you still have to tell the IRS that you don't have to include the forgiven debt as income and why. You will need to file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your income tax form.
If you have questions about your debt that was canceled, forgiven, or discharged and whether you have to pay taxes or not, don’t hesitate to contact us for your free consultation. We can answer your questions and ensure you have a plan in place to stay on top of your finances in 2018.