Cancelled Debt as Taxable Income

Debt settlement occurs when a debtor successfully negotiates a payoff amount for less than the total balance owed on a debt.

For many individuals, a successful debt settlement outcome is cause for celebration – after all, the debt settlement process can take several months or longer – and who wouldn’t be a little excited after learning that a significant amount of money once owed can now be treated as cancelled debt?

However, there is a catch. If the amount of cancelled or forgiven debt is $600 or greater, the IRS requires that it be treated as taxable income on Form 1099-C when filing income tax for the following year. Let’s take a closer look.

Form 1099-C

When a debt in the amount of at least $600 is forgiven or cancelled through the debt settlement process, the IRS requires the creditor to send the debtor a 1099-C tax form that stipulates the amount of the cancelled debt.

However, the prevailing tax law does not require businesses to inform debtors of the tax implications of debt settlement, and, as a result, many of the approximate 4.3 million consumers who will receive a 1099-C in early 2019 will underestimate or ignore its importance when filing their income tax.

In fact, because many 1099-C forms are sent by the same debt collector with whom the debtor successfully settled, the 1099-C often gets discarded under the assumption that it is irrelevant and outdated. Unfortunately, nothing could be further from the truth, as the IRS will also have received a copy of the 1099-C.

Income Tax

The stark reality is that one year’s cancelled debt usually becomes part of the following year’s income tax liability. Consequently, a failure to include Form 1099-C with an income tax filing can lead to IRS fines, penalties, and interest expense – and possibly even an audit.

If you have successfully settled credit card (or other unsecured) debt of $600 or greater, be on the lookout for your 1099-C form and take it to a knowledgeable tax professional prior to filing your income tax return.

When income from a 1099-C is omitted from a tax return, the IRS can reject the return or send back a corrected return along with a bill for the amount due. Another common outcome is the disappointingly small tax refund that may result from omission of the 1099-C.

Some Cancelled Debt is Tax Exempt

There is some good news here. There are several exclusions that allow taxpayers to reduce the amount of taxable income resulting from cancelled debt. Debts that have been discharged through bankruptcy are not treated as taxable income, for example.

The same goes for student loans that have been forgiven by an educational institution that is tax exempt and the debtor has been employed by a qualified employer for a required period of time.

Similarly, mortgage debt on a primary residence that has been foreclosed upon, restructured, or sold in a short sale (when the home value sinks beneath the outstanding mortgage debt) is not subject to income tax after the debt has been forgiven.

Insolvency Income Tax Exclusion for Cancelled Debt

Finally, when an individual is insolvent (liabilities exceed the fair market value of assets), cancelled debt is excluded from income tax by the amount of the insolvency.

For example, when $7,000 of debt is forgiven, and liabilities exceed assets by $3,000, then $3,000 of the cancelled debt is not subject to taxation. The remaining $4,000 of cancelled debt, however, is subject to income tax.

In this instance, as well as those discussed in the previous paragraph, the debtor must file an IRS Form 982 along with the 1099-C form to benefit from the income tax exclusion according to tax law.