Feeling relieved after finally settling your credit card debt? Fantastic–but you’re not in the clear yet. It turns out, according to the IRS, your forgiven debt counts as income. Many taxpayers who think they’d seen the last of their debt are slapped with a 1099-C form come tax time.
What is a 1099-C Tax Form? What Does it Have to do With You?
A 1099-C tax form is an indication that “a creditor is going to ‘write off’ the remaining portion of your debt,” says the IRS. They go on to explain, somewhat ominously, that although you may “have reached a compromise or settlement with a creditor agreeing to release you from any further obligations regarding the repayment of a debt, a credit card debt for example, your responsibilities may not end at this point.”
So What Does this Have to do With Me?
When your debt has been forgiven, you may think that the only lasting damage will be to your credit score. Not so, says Kevin Gallegos of Freedom Debt Relief. “If Bank A writes an account [debt] off, or takes a settlement and therefore accepts a partial loss on an account, accounting rules say that the consumer needs to take that loss as a gain, and that gain is treated as taxable income.”
Basically, the creditor takes a loss when forgiving your debt. Since they’ll claim a tax deduction from that, someone is going to have to pay for the gain. That someone is you.
Specifically, if you owe more than $600 in debt, the creditor is required to send you an IRS 1099-C tax form and the IRS says you must claim that amount as income.
And don’t expect the IRS to automatically send you the 1099-C form, or even your creditor to tell you that you have to pay. You’ll have to claim the amount of the unpaid debt as income, or face a tax bill or a costly audit.
Exceptions to the Rule
There are five incidences where you don’t have to recognize your debt as income, according to the IRS:
- Insolvency (when you settled your debt, you owed more than your total assets)
- Indebtedness due to farm expenses
- If your debt was reduced due to a mortgage restructuring, short sales or foreclosure on your primary residence
- If your debt settlement is treated as a gift
In order to claim insolvency (exception #2), you must fill out a 982 form. Be careful, though, when filling it out: In addition to double-checking that you were insolvent when your debt was settled, you must send a letter with the form detailing your calculations for debts and assets.
And here’s the really confusing part. Let’s say your assets are $30,000 and your debts total $40,000 before you settled, so you’re $10,000 in the red. Your creditor writes off $14,000 of that debt–$4,000 more than how much you’re insolvent by. That $4,000 is now added to your income. Again:
Extra Income = [Amount written off] +[Assets] – [Liabilities]
But Wait, There’s More!
As you might have noticed, one of the exceptions is for debt incurred because of your primary residence. Unfortunately, that means that the 1099-C applies to mortgage debt as well as credit card debt. You’ll have to pay income tax for the difference between what you owe and what the lender sells your property for (called the deficiency).
Again, an exception is made for loans that you used to buy or improve your primary residence, or if you were insolvent at the time.
What You Can Do
When you settle your debt, ask the lender to consider the debt paid in full. If they do, they won’t write it off as a loss, and you won’t have to report it as income. The lender can refuse, of course, but if you’re persistent, they should try to help you.
If this sounds way too confusing to you, that’s understandable. The 1099-C is a virtual minefield for taxpayers. It’s probably a good idea to seek professional tax help if you’re going to be filing one.