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Note: This article is for information purposes only.
Did you know that the Internal Revenue Service considers forgiven debt a source of income and that you might have to pay taxes on it? If you’ve ever settled a debt for less than you owned or had debt forgiven entirely, you probably got a surprise in the mail come tax season. The surprise is a Form 1099-C.
If you got a 1099-C for cancellation of debt in the mail, don’t worry. A few exclusions do apply, and you might be able to avoid paying taxes on this canceled debt. Discover more about canceled debt and what type of tax burden it can cause below.
What Is a 1099-C?
A 1099-C reports Cancellation of Debt Income (CODI) to the IRS. According to the IRS, if a debt is canceled, forgiven or discharged, you must include the canceled amount in your gross income and pay taxes on that income unless you qualify for an exclusion or exception. Creditors who forgive $600 or more of debt for you are required to file Form 1099-C with the IRS.
Form 1099-C is more common than you might think. According to the IRS’s Office of Research Publication 6961, it received more than 3.9 million 1099-Cs in 2018. It projected more than 4.3 million people will receive 1099-Cs in 2019. Estimates for 2020 are 4.4 million.
What Should I Do If I Get a 1099-C?
First, don’t ignore a 1099-C or canceled debt. The IRS is looking to have that income included in your tax return unless there’s an exception or exclusion.
Even if you don’t get a 1099-C, you should track canceled debt. A creditor could’ve submitted the form to the IRS and you never received your copy. You may still need to claim the income and pay taxes on it.
Next, figure out if you qualify for an exclusion or exception. Figuring out how much you have to pay can be complicated. If you’re accustomed to doing your own taxes, this is a situation where it can really pay to get expert advice from a tax professional. A tax professional can help you determine whether you can reduce the amount of canceled debt you have to pay taxes on or skip paying taxes on it altogether as a result of one of the following exceptions or exclusions.
When Is a Canceled Debt Excluded From Taxable Income?
Canceled debts that can be excluded from income and that you don’t have to pay taxes on, at least partially, are called “exclusions to cancellations of debt income.” They include:
- Cancellation of qualified principal residence indebtedness that happens before January 1, 2018
- Debt canceled in a bankruptcy
- Debt canceled due to insolvency (not being able to pay your debts)
- Cancellation of qualified farm indebtedness
- Cancellation of qualified real property business indebtedness
Keep in mind that you can only use the exclusions—the second list—after you apply the exceptions. And, if you use the exclusions, you likely have to do some fancy tax footwork known as reducing your tax attributes.
Sound confusing? Dealing with the debt forgiveness tax definitely can be, which is why a tax professional can be very helpful. For full details see IRS Publication 4681 (2019), Canceled Debts, Foreclosures, Repossessions, and Abandonments.
My Debt Qualifies for a 1099-C Exception? How Do I Get One?
If you qualify for an exclusion, you must complete and submit Form 982. It may not be easy. The title of the form alone, “Reduction of Tax Attributes Due to Discharge of Indebtedness and Section 1082 Basis Adjustment,” is intimidating. To help you get started, let’s take a look at two of the most common exclusions that apply.
1. Debt Canceled in a Title 11 Bankruptcy Case
You don’t have to pay tax on debt successfully discharged in bankruptcy. Title 11 refers to the section of the U.S. Code that’s referred to as the Bankruptcy Code. This doesn’t mean only debts wiped out in a Chapter 11 bankruptcy qualify for this exclusion.
However, if you settled a debt before you filed for bankruptcy, the creditor may still send you a 1099-C indicating the forgiven amount. And you’ll have to research whether there are other exceptions or exclusions you can use to avoid paying taxes on that amount.
2. Debt Canceled Due to Insolvency
Along with bankruptcy, insolvency is one of the most common exclusions taxpayers use to avoid paying taxes on canceled debt.
Here’s how it works. You make a list of the value of all your assets and a list of all the debts you owe. That includes debts that may not be dischargeable in bankruptcy, such as student loans. You’re insolvent to the extent that your liabilities exceed your assets. Here are a couple of examples:
- Your assets are worth $35,000, and your debts total $45,000. You’re insolvent to the tune of $10,000. You settle a debt with a creditor who agrees to forgive $8,500. You don’t have to report any of that money as income on your tax return.
- Your assets are worth $35,000, and your debts still total $45,000, but the creditor writes off a $14,000 debt. You don’t have to report $10,000 of the income, but you will have to report $4,000 as income on your tax return. And you have to fill out Form 982 to demonstrate to the IRS why you aren’t including the amount listed on the 1099-C in your taxable income.
What Can I Do if I Paid Taxes on a Debt That Was Excluded?
Taxpayers who erroneously pay taxes on forgiven debt can go back and amend prior year’s tax returns and could get a refund for those years. But you only have three years to file an amended return for this purpose.
To amend a previous tax return, collect all the documents you need, including the original tax return you filed. Then, download all the forms you need. Tax Form 1040X can be used to adjust income and amend a previous return.
Make sure that this adjustment compensates for the amount of your forgiven debt. If you’re claiming any exclusions when you refile, explain why. You can’t e-file amended tax returns, so you’ll need to mail your completed paperwork directly to the IRS.
Review our Tax Learning Center for more help with your taxes.