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Some canceled debts are treated like income by the IRS. If you receive a 1099-C form, you’ll need to pay taxes on your forgiven debts.
Getting a reprieve from debt you owe can be freeing and relieving. But did you know that some forgiven debts are treated like income by the IRS? That means you might end up owing taxes on the canceled amount. If you had debt forgiven last year, you may receive a 1099-C cancellation of debt tax form in the mail soon. Find out more about the 1099-C form and how it could impact your tax liability.
In This Piece
What Does It Mean When a Debt Is Canceled?
Debt is considered canceled when it’s forgiven or discharged even though you didn’t pay it back as agreed. Here are a few examples of times when a debt is considered canceled.
- You owe a credit card company $10,000 and are behind on payments. The credit card company has filed a lawsuit or otherwise notified you about the collections activity. You negotiate, agreeing to pay $6,000 to have the debt considered paid in full. The credit card company agrees to this settlement, which means $4,000 of your debt has been canceled.
- You buy a car for $30,000 and make a total of $10,000 in payments. You can no longer afford the payments and fall behind on payments. The bank repossesses the car, but you still owe $20,000 on it. If the car is worth $15,000, the bank can sell it and recover that much of the loan—leaving $5,000 of debt to be canceled.
- You file for bankruptcy with $60,000 in unsecured debts, which are all discharged. That debt is also considered canceled.
Not all debts that are canceled require a 1099-C. They also don’t all impact your taxes. If you had any debts canceled or expect to receive a 1099-C, you may want to work with a professional tax service to file your 2020 taxes.
What Is a 1099-C Cancellation of Debt?
A 1099-C is a form used to report various types of income. It’s one of several 1099 forms that are used to report income that isn’t reported on W-2 forms. You might get 1099 forms if you have rent, royalty, or contract income, for example. Typically, the rule for 1099 forms is that if someone pays you $600 or more within a year, they must report it on a 1099—and you need to report it on your taxes.
The 1099-C form is specifically used to report income related to cancellation of debt. The IRS considers forgiven debt as income because you received a benefit without paying for it. If you borrowed $10,000 and only paid back $4,000, for example, then at some point you ended up with an “income” of $6,000.
According to the IRS, 1099-C cancellation of debt forms are used in the following situations:
- The debtor can’t collect or gives up trying to collect a legitimate debt
- The debtor agrees to settle a debt and not collect all of it
- You voluntarily surrender property to the lender and the property value doesn’t cover the total amount you owe—one example is a home short sale
- Property is foreclosed on or repossessed, and the value doesn’t cover the total amount you owe
- Your mortgage is modified due to inability to pay as agreed, and you end up owing less
The IRS notes that creditors do not need to issue a 1099-C cancellation of debt in some cases:
- Debts being canceled as a gift or through inheritance
- Some student loans that are canceled
- Certain credits provided by property buyers
- Certain reductions under the Home Affordable Modification Program
Can a Creditor Collect After Issuing a 1099-C?
A creditor cannot continue to collect after it issues a 1099-C. When it issues a 1099-C, it’s stating that it considers the debt canceled or forgiven. You no longer owe the debt, which is why the IRS may now consider it income.
It’s important to note that just because you don’t owe the debt doesn’t mean your credit won’t still be impacted by it. Canceled accounts may still show up on your credit report—along with notes about any payments that you missed before that point—for up to 7.5 years. Not only are canceled debts a hit to your credit score, they can cause future lenders to question whether you’re someone who makes payments on debts as agreed.
How Does Cancellation of Debt Affect Your Taxes?
In many cases, canceled debt may add to your taxable income. This can increase how much you owe the IRS or eat into your expected tax refund. Here’s an example:
- You made $40,000 this year, and due to higher-than-necessary withholdings on your paycheck, you’re expecting a $1,000 refund.
- You also settled debts for $15,000 this year. That means the IRS might consider you having $15,000 more in income—bringing you up to $55,000.
- You didn’t yet pay taxes on that $15,000, so you may need to do so in April. Depending on all other factors, that tax amount could take your entire $1,000 refund, and you could owe even more.
Not all canceled debt works against you when it comes to tax burdens, though. The IRS provides a list of exceptions of 1099-C canceled debt that isn’t added to income. That includes:
- Certain debts canceled or discharged in bankruptcy
- Certain qualified farm debts
- Certain qualified business debts
As you can see, whether or not a canceled debt is counted as income for federal tax purposes can be a complex topic. The bottom line is that discharged debt may come back to burden you in the form of additional income on your tax return, so it’s important to be aware of this possibility.
Prepare Your Taxes Now
If you’re working on your taxes and have received a 1099-C form, consider consulting with a tax professional or using tax software. Free tax filing services may not include all the right options for filing with this type of income, especially if you don’t have a deep understanding of the rules. Software walks you through completing the proper tax return forms by asking you questions and ensuring you’re including all the right forms and income.
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