Tax on Cancellation of Debt
Avoid Surprise Tax Bills

Tax on cancellation of debt can be a real surprise if you have recently settled your credit card debt for less than you owed or were able to get the principle reduced on your mortgage and thought all of your problems were over. You might get a little surprise in the mail before tax time.

Many consumers who have debt problems are shocked when they get a little piece of paper in the mail telling them that their recent cancellation of debt has resulted in a new tax liability.

With the slow economy and weak job market creating a sluggish financial environment many people have opted to resolve credit card debts by settling with their credit card companies. However, following a successful settlement many receive a IRS form 1099-C in the mail and aren't sure why. This particular form is called a cancellation of debt notice. The United States Internal Revenue Service considers canceled or forgiven debt as income.

Why Do I Owe Taxes On Forgiven Debt?

When a creditor or debt collector agrees to take at least $600 off the original balance of a loan or debt they are required by law to submit this inforamtion to the IRS and send the debtor a notice as well. As a taxpayer, you must report the debt reduction as income on your federal tax return. The problem is that most people don't know that this is coming and are shocked when they open their mail to find that they're going to have to pay taxes on the money they saved.

Let's say a person has $10,000 in credit card debt but is able to negotiate a debt settlement for $6000. That would mean $4000 was forgiven debt. Now, that person must claim that $4000 as other income on their IRS tax forms. Depending upon the taxpayer's income level, deductions and other criteria, the consumer can actually end up paying a sizable amount of additional taxes due to the forgiven debt.

Don’t Trash The 1099

One of the problems with getting a 1099-C tax form in the mail is that many people have no idea that it's coming and they simply throw it away. When they see that it is addressed from a creditor, many assume it is just part of their settled debt and either file somewhere or toss it in the trash can. There are severe implications to doing this so make sure you read the form and handle it properly. You risk fines, penalties and even audits for not reporting income on your tax return.

Avoid Paying Tax on Cancellation of Debt

The best advice for someone who receives one of these forms in the mail and doesn't understand what to do with it is to consult with a tax professional. There are other exclusions that a taxpayer may meet that will allow them to reduce their taxable income liability from a canceled debt.

One exclusion applies to debts that were discharged under a bankruptcy. Another refers to consumers who are insolvent prior to the cancellation of debt, which means that their liabilities are more than their assets.

A homeowner who has defaulted on their mortgage may qualify under the Mortgage Forgiveness Debt Relief Act for an exclusion to income of a cancelled debt. This act helps homeowners who are caught up in the mortgage crisis and generally applies to debt that was forgiven between 2007 through 2012. If you had part of your mortgage forgiven as part of a bank or government program you may find you qualify for an exclusion on that basis as well.

Some other exclusions that may apply to you relate to student loans, real property business debts and some specific farm debt. If you think any of these may apply to you, speak with your tax professional to find out how to properly document everything and take the maximum income or tax reduction allowed by law.

When it comes to tax on cancellation of debt, it would be very helpful to the consumer if credit card companies and the IRS were clearer on explaining when this added income might apply. It is always best to expect that taxes are due rather than be surprised by a 1099 arriving in the mail.