Debt Forgiveness, Taxes, and the 1099c

Analyzing Financial DataBankruptcy can avoid taxes on debt forgiveness and avoid the impact of a 1099c. Let’s say you are working with a debt negotiator or a collection agency and work out a favorable deal. You negotiate a debt from $25,000 down to $2,500 (which I just did for a client recently.) Sounds great. Well, it can be but only if you know the rest of the deal. The 1099c is the part that the debt negotiator doesn’t tell you about or puts in the “fine print.”

The amount forgiven is considered taxable income by the IRS and the creditor is obligated to report it to the IRS if the amount forgiven is more than $600.  The creditor will issue a 1099c. In my guy’s case, he will get a 1099c for $22,500 and have to pay taxes on it which is fine as long as you know that going in and take it into consideration. Here is the IRS publication with some details.

You won’t always have to pay taxes on the amount forgiven. The exceptions:

  • the debt was a non-business debt and was canceled before 2007 as a result of Hurricane Katrina
  • a student loan was canceled because you worked in a profession and for an employer as promised when you took out the loan
  • the canceled debt would have been deductible if you had paid it
  • the cancellation or write off of the debt is intended as a gift (this would be unusual)
  • you discharge the debt in a bankruptcy proceeding
  • you were insolvent before the creditor agreed to settle or write off the debt

If you cannot afford to pay the taxes on it you better not agree to it because you do not want to owe Uncle Sam.

These rules also apply to deficiencies after a foreclosure or short sale. It sounds pretty unfair to get a 1099 after you lose your house.  Under the Mortgage Forgiveness Debt Relief Act of 2007  certain loans will be partially or wholly forgiven from 2007 through 2012. If the real estate is your primary home and the loan was for the purchase or improvement, then there is no tax consequence. If the loan was for investment property or used for something else, e.g., you took out a second mortgage for a credit card consolidation payment, you are going to pay taxes on it.

Bankruptcy may be a good alternative to negotiation. There are no tax consequences to discharging your debt or surrendering a house in a bankruptcy. None. In a Chapter 7, you can discharge all your debt, pay your creditors nothing, and not have any tax consequences. If you negotiated a debt, you may want to file for bankruptcy before the 1099c comes, especially if didn’t know about it and aren’t ready.

Keep in mind, I am just a bankruptcy lawyer and not an accountant. If your accountant knows more than I do, take his word for it. I am just bringing this issue to your attention because it takes a lot of my clients by surprise.

To learn more about bankruptcy and what I can do for you, please take some time to read The Bankruptcy Book.

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Creative Commons License photo credit: Dave Dugdale