Cancellation of Debt Income

With the tough economic times we are currently enduring, many people unfortunately find themselves unable to meet their financial obligations. In preparing our clients’ tax returns we are seeing an increasingly larger number of 1099-C (Cancellation of Debt) and 1099-A (Acquisition or Abandonment of Secured Property) forms. What are these forms, why are you receiving them, and what should you do if you receive one? When property is security for a loan and the lender forecloses on the loan, or property is abandoned (the owner walks away from it) the lender prepares a form 1099-A to provide the information needed to calculate the amount of gain or loss from the cancellation of debt that is not related to a personal residence. If a debt of $600 or more is cancelled by the lender, you may receive a form 1099-C. If the foreclosure or abandonment and cancellation of debt occur in the same year, the lender may file only a form 1099-C. Do not ignore these forms if you receive them!

The lenders are required to mail copies of these forms to the Internal Revenue Service as well as to you. If you receive one of these forms you must either :

(1) report the amount of the cancelled debt as income on your tax return; or

(2) tell the IRS on Form 982 that the amount is not taxable because you fall under one of the three common exceptions:

a.) The debt was discharged in bankruptcy before it was written off by the creditor (lender)

b.) You were insolvent – i.e. Your liabilities (the total debts or amount you owed on loans and credit cards) are/were more than the value of your assets (all the property you owned including retirement accounts).

c.) If you had $5,000 in debt forgiven, and your liabilities exceeded your assets by $2,000, you would have to pay cancellation of debt income on only $3,000. The $2,000 of insolvency would be exempt from taxation.

Exclusion from income for “acquisition debt” on a personal residence (discussed later in this article).

How, you may ask, can the forgiveness of debt be income? The IRS in their great wisdom looks at it this way. Instead of getting paid money that would be income to you, and using it to buy something, you could just “borrow” the money (buy something on credit, take equity out of your house, or get a loan) and then have the lender just write off the loan (result you got the money or what you bought and never had to pay tax on the “income”, the amount of the loan or credit extended to you). To avoid this situation the IRS requires a lender to report the cancellation of debt to you as income. It is up to you to report the income or explain why you meet an exception that makes the amount of debt cancelled not income to you. Let me give you an example. A person with $10,000 in credit card debt gets behind on their payments and negotiates with the credit card company to settle their account as paid in full with a $6,000 payment. The credit card company writes off the remaining $4,000 owed to them and then generates a form 1099-C to report the transaction. Part of the problem occurs when the debt is written off in one year, and the 1099-C form isn’t generated until the next year. The borrower thinks their money woes are over when they settled the credit card debt for 60 percent of what was owed, only to find out they owe tax on the forgiven debt. Too often people don’t understand the 1099-C forms and throw them away, only to get a notice from the IRS for tax, penalties (can be up to 25 percent of the tax) and interest on the unreported income. Another problem occurs when a person receives a 1099-C form, but doesn’t recognize the name of the creditor that appears on the 1099-C form, so they think “this can’t be mine, I never had a loan with them”. The debt may be owned by a parent corporation, or the debt may have been sold or assigned to a third party collection agency, who then generates the 1099-C form. An example is that a debt for a Discover card will list “Greenwood Trust” on the 1099-C form.

What about debt forgiveness on a house? For calendar years 2007-2013, cancellation of debt income on a personal residence is not taxable if the mortgage debt forgiven was on loans used to buy the house (hence the term “acquisition debt”) or from refinanced debt which was used to make improvements to the home. If you use the proceeds of a home equity loans or refinanced mortgages to pay off credit cards, or for something other than making improvements to the house, that portion will not qualify for exclusion from debt forgiveness income. Taxes filed by the April 2014 deadline will be the last opportunity to claim the mortgage debt forgiveness exemption – unless Congress passes an extension.

Financial institutions frequently do not actually relieve debt in the year of foreclosure, you have the additional problem of explaining to the IRS why cancellation of debt income is reported in a year when no 1099-C was issued or why the cancellation of debt income is not included in a year the 1099-C is issued (so the taxpayer is given the responsibility of explaining why the financial institution didn’t do their job properly). If you meet one of the exclusions listed above and do not have to report some (or all) of the cancellation of debt income, you are not done yet. If you escape reporting of cancellation of debt income, you are then required to reduce the tax basis of property you may own, which may result in a gain when that property is later sold, or reduce the benefit of tax credits, net operating losses or tax carryovers/carrybacks. Suffice it to say if you receive a 1099-A or 1099-C form, do not ignore the form and seek assistance from someone who is knowledgeable in these matters.