Forgiven debt can be a huge source of relief. If you’ve settled a debt with a lender, had a loan written off due to non-payment, or gotten rid of a home you can no longer afford, it may feel like a financial win—until you receive Form 1099-C in the mail. Unfortunately, forgiven debt is often treated like income, and you may have to pay taxes on it.
Many taxpayers don’t realize that they have to pay taxes on cancelled debt until they have already settled their debt, resulting in an unpleasant tax bill that puts them back into the cycle of debt they were trying to escape. Some types of forgiven debt are non-taxable, but even if your forgiven debt is taxable, there are options for relief.
Key Takeaways
- Cancelled debts are generally reported on Form 1099-C.
- The reported amount is often taxed as income.
- Failing to report that amount may result in the IRS changing your tax return.
- There are situations in which cancelled debt is non-taxable.
- If you owe taxes on your cancelled debt, there are payment options available.
Why Cancelled Debt Can Lead to a Tax Bill
When a lender forgives a debt via a settlement, write-off, repossession, or foreclosure, the IRS views that as the lender giving you money. Borrowing money and then not repaying it is viewed as a source of income, and the IRS taxes it as such.
Form 1099-C
When a lender forgives a debt of $600 or more, they report it to the IRS on Form 1099-C. Both you and the IRS should receive a copy of this form. The IRS then knows to look for it on your tax return.
For example, say that you owe $10,000 on a credit card. You don’t pay for months. The account goes to collections, and then, you settle for just $2000. The lender will send you a 1099-C showing the $8000 in cancelled debt.
What Happens If You Don’t Report It
If you don’t include your Form 1099-C on your tax return, either because you didn’t know about it or because you didn’t want to pay taxes on it, the IRS’s automated system flags the mismatch between your tax return and what third parties reported to them. The IRS will then send you Notice CP2000, which informs you of the discrepancy and the IRS’s intent to adjust your tax return.
Should you agree to the adjustment or ignore the notice, they will change your tax return and send Notice CP3219A to notify you of a deficiency.
Common Situations That Lead to Cancelled Debt
Cancelled debt is far more common than most people think. It’s easy to fall behind, especially in a tough economy where there’s always a new challenge waiting around the corner. Some common situations resulting in cancelled debt include:
- Credit card settlements—for example, paying $3,000 on a $10,000 debt to have the entirety of the debt written off
- Auto loan deficiencies—common when the lender repossesses your car, sells it, and there’s still a balance on your loan
- Mortgage short sale or foreclosure—often happens when a borrower owes more than the home is worth
- Personal or business loan charge-offs—may happen when a lender stops trying to collect and just reports the loss to the IRS.
In these and similar situations, the lender may report the debt to the IRS via Form 1099-C.
What If You Can’t Pay the Tax? IRS Relief Options
If your forgiven debt turns into a tax liability and you cannot pay the tax bill by its due date, don’t panic. The IRS is no stranger to financial difficulties, and there are numerous payment options available to taxpayers who cannot pay in full. Options you may want to explore include:
- Simple installment agreement: This is often the easiest option for taxpayers, since it does not require financial disclosure forms or a long application. Your tax debt is spread out over up to 10 years of monthly payments. There are also other payment plans available.
- Offer in compromise: This option is suitable for those who cannot afford to pay their tax debt in full, either upfront or over time. Your income and assets have to be limited enough to prevent payment in full, and the IRS checks this via extensive financial documentation.
- Currently not collectible: While this isn’t a permanent solution for most people, it does give you some breathing room to figure out your next steps. The IRS may consider you currently not collectible if you are unable to pay anything because of your financial limitations. They check on your financial status occasionally to see if you are able to resume payments.
You may also want to look into innocent spouse relief, particularly in situations when you’re dealing with tax debt after a divorce, and you weren’t aware that your spouse had cancelled debt that led to a tax liability.
When Cancelled Debt is Not Taxable
Before giving up, you may also want to see if your cancelled debt should be non-taxable. Several forms of forgiven debt can be non-taxable, including:
- Debt discharged in bankruptcy
- Debt from farming or business items required for your work
- A foreclosure on your primary residence (note that this is a temporary exclusion, so check with your tax professional)
- Debt forgiven when you are insolvent
Even if you received a 1099-C, the debt might not be taxable. However, you can’t get the debt excluded automatically—the IRS requires that you report it on Form 982.
The Role of Form 982
Form 982 allows you to document non-taxable cancelled debt so the IRS does not tax you on the forgiven amount. You have to include the non-taxable amount and the category under which you qualify.
How These Situations Play Out in Real Life
If you’re in this situation and you’re panicking, please know that you are not the first or last person to go through this. Thousands of people have been unpleasantly surprised by a huge tax bill after having debt forgiven. Consider these scenarios:
- Taxpayer A accumulated a $20,000 credit card balance while laid off. After months without payment, they settled for $3,000 with the credit card company. They did not realize they had to pay taxes on the $17,000 that they saved until they received a 1099-C. They worked with a tax attorney and found out that they were considered insolvent at the time of the forgiven debt, allowing them to avoid paying tax on any of the forgiven debt.
- Taxpayer B had a personal loan of $15,000 written off due to non-payment. At tax time, the 1099-C resulted in a huge tax bill. They applied for a simple installment agreement and found that they could afford the minimum monthly payment.
- Taxpayer C had their vehicle repossessed and sold, but there was still $7,000 on their loan that the lender wrote off. Because of their dire financial situation, they were able to secure an offer in compromise that required them to pay a fraction of their tax debt.
What to Do Next—and How a Tax Professional Can Help
If you’ve received a 1099-C and you’re not sure how to proceed, take a few minutes to read the form in full. It includes everything you need to know about the debt and where to get more information. You may also want to look into situations in which forgiven debt is non-taxable to see if you qualify.
If you do not qualify, you can still look into payment relief options, such as an installment agreement or offer in compromise. You can take an in-depth look at your finances to see which forms of relief you may qualify for.
You may not know if you qualify for non-taxable status or not. In that case, it’s important to talk to a tax professional about what comes next. There are a lot of limits and strict qualifications in this area of tax law, and you may qualify to have some or all of your forgiven debt excluded from your taxable income.
Even if you do have to pay taxes on your forgiven debt, your tax professional can help you compare repayment options, decide which options are best suited to your current needs, and navigate the application process.
If you’ve been hit with a tax bill for forgiven debt, don’t wait to see what the IRS will do next. Call Seattle Legal Services at 206-536-3152 or contact us online to learn more about your options.
Frequently Asked Questions
My debt was forgiven because I had no money to pay my debt with—can’t this help me with my taxes too?
Possibly. If you were considered insolvent at the time of the forgiven debt—which means having more liabilities than assets—you may not have to pay taxes on the forgiven amount. A tax professional can help you figure out if you qualify.
What happens if I ignore a 1099-C?
The IRS may make adjustments to your tax return, update your tax bill, and start enforcing collection actions.
Is debt from forgiven loans and credit cards treated the same way?
Generally, yes. While there are exclusions, most forgiven loans and credit cards are treated as taxable income by the IRS.
Will forgiven tax debt lead to a tax bill?
If you get back taxes forgiven, the IRS will not generate a 1099-C. That’s because the IRS typically only forgives tax debt when people are insolvent, and thus, the cancelled debt is not considered to be income.
Sources:
https://www.irs.gov/taxtopics/tc431
https://www.irs.gov/newsroom/what-if-my-debt-is-forgiven
https://www.taxpayeradvocate.irs.gov/get-help/general/cancellation-of-debt/
https://www.irs.gov/taxtopics/tc652
https://www.irs.gov/individuals/understanding-your-cp2000-series-notice
https://www.irs.gov/pub/irs-pdf/f982.pdf
https://www.irs.gov/newsroom/what-if-i-am-insolvent