1099C received from creditor?

Tax returns were just due, which means that I have gotten several calls from clients who have gotten a 1099C form from their creditor and want to know what to do.

A form 1099C is an IRS form (like a W-2) which a creditor uses to tell the IRS that a debt was forgiven, in whole or in part.

The IRS will get the form 1099C from the creditor and will think that you have taxable income.  This is because usually the cancellation of debt is a taxable event.  Say that you owe Discover Card $5,000, and you settle the debt by paying Discover Card $3,000.00.  On paper you are $2,000 better off ($5,000 owed minus $3,000 paid = $2,000 improvement), and that $2,000 looks like income.  As the basic rule is that income is taxable, it looks on paper as though you "made" $2,000.00.  

There are five exceptions to this however, of which two are most common.  You use IRS Form 982 to tell the IRS that one of the exceptions applies to you.

You can get Form 982 and the instructions at the IRS website, which is www.irs.gov  Also useful is Publication 4681, which goes into more detail and gives examples.   Both of these are free to download.

The first major exception to having to recognize cancelled debt as income is that the cancellation of the debt took place in a bankruptcy.  In my practice that is the most common.  Unfortunately, some creditors will send the 1099C even though the debt was discharged in a bankruptcy.   If your tax preparer does not ask you if you filed bankruptcy, you may wind up paying tax on cancellation of indebtedness income, even though the bankruptcy exception applies.  The moral of this part of the story:  Tell your preparer about your bankruptcy discharge and be sure a Form 982 is included in your filing, if applicable.

The second major exception, applicable outside of bankruptcy, is that after the cancellation of the debt you were still insolvent (meaning, you owed more than your assets were worth).  For example, let's say that you own nothing in the world except household goods and clothing worth $4,000 and a car worth $3,000 and $3,500 cash in the bank.  At the same time you owe Visa $4,000, MasterCard $3,000.00 and Discover Card $5,000.  So, your assets add up to $10,500;  your liabilities add up to $12,000.00.  You are insolvent by $1,500.  So, if you settle your Discover Card for $3,000.00, your situation now looks like this:

household goods and clothing $4,000
car $3,000
cash $500
total of assets: $7,500.00

Debts:

Visa $4,000
MasterCard $3,000
Discover Card $0
total of debts:  $7,000.00

So, before Discover Card cancelled $2,000 worth of debt,  you were insolvent by $1,500;  the cancellation of debt in the amount of $2,000 thus made your assets in surplus by $500.  Thus, in this example, you would have to claim $500 of income on your tax return from the $2,000 that Discover Card cancelled.

As you can see, the second major exception will involve some amount of math.

The point of this post, however, is to tell you  to not simply accept the 1099C as income;  get Form 982 and the instructions from the IRS website, fill it out, and file it with your taxes.  It may save you a lot of aggravation later on!

I  should add that there are three other exceptions, and that there is a very important one relating to "qualified principal residence indebtedness", meaning the mortgage against your home.  

For more details, get Publication 4681, which has a number of examples.

 CIRCULAR 230 NOTICE: In accordance with IRS Treasury Regulations, we are required to notify you that any tax advice given herein (including attachments) is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding any penalties that may be imposed by any governmental taxing authority or agency or (2) promoting, marketing or recommending to another person any tax related matter.