Negotiating your way out from under a large debt can be a tremendous relief. No more stressful calls from the creditor or a debt collector trying to squeeze a payment out of you when you’re just getting by. No worries about a lawsuit, wage garnishment, or other disruptive collection activity.
Sometimes, though, that sense of relief is followed by an ugly surprise. If you’ve settled the debt for less than the full balance or the creditor has forgiven the debt, there may be another bill on the way–from the Internal Revenue Service (IRS).
When is Debt Elimination Taxed as Income?
If you owe $5,000 on a credit card account and settle the account for $2,000, you’ve received a $3,000 benefit. Yesterday, you owed that $3,000 and because of your negotiating skills, you didn’t have to pay it and today the debt is gone. Depending on the specifics of your situation, the IRS may consider that benefit taxable income.
That may be true whether you settle the debt yourself, negotiate through an attorney, or use a debt settlement company. It may also be true whether you make a partial payment in full settlement or the creditor writes off the debt entirely.
The possibility of tax consequences doesn’t mean you should avoid settling debts. The tax on the forgiven or canceled debt will obviously be significantly less than the debt itself. But, if you’re not prepared for it, that tax bill can come as a shock. And, debt to the IRS is different.
The federal government has more extensive debt collection options than private creditors, and income tax debt generally isn’t dischargeable in bankruptcy unless it’s at least three years old and certain other conditions are met.
If you’re considering settling a debt with partial payment, or negotiating for a creditor to write off a debt, it’s important to understand when this type of reduction or elimination is taxable and how you can plan for that.
When to Expect a 1099-C
You may have received 1099s before. They’re a type of tax form you receive when you’ve received income in a non-employee role. If you’ve done work as an independent contractor, you may have received a 1099-MISC or a 1099-NEC. If you’ve earned interest on a bank account or brokerage account, you may have received a 1099-INT.
If you’ve had a financial obligation canceled, you may receive a 1099-C. Like other 1099 income, amounts reported on a 1099-C are added to your annual income for tax purposes. In California, that means the income is carried over to your state income tax return, too.
However, there are exceptions–situations in which debt is eliminated, discharged, canceled, or reduced and does not result in taxable income. For example, certain types of student loan debt cancelation are not considered taxable income. And, cancelation of a debt as a gift or bequest typically doesn’t result in taxable income.
There are also several exclusions. Most of these are quite specific, such as the exclusion of certain types of farm-related debt. But, there are two exclusions that impact many people who have been struggling with debt and have seen some of that debt wiped out.
Key Exclusions to Canceled Debt Taxation
Canceled debt is generally not considered taxable income if the debtor was insolvent at the time of the cancelation. But, it’s important to understand exactly what “insolvent” means.You may be cash poor and unable to pay your bills and still be legally solvent.
Determining solvency for tax purposes involves adding up all of your assets and all of your liabilities and subtracting. If your liabilities are greater than your assets, you’re insolvent. In this limited circumstance, that’s good news. But, being insolvent doesn’t necessarily mean the entire amount of the canceled debt will be free from taxation.
The next step is to determine the extent of the insolvency. In simple terms, that’s the amount by which your liabilities are greater than your assets. If you have $90,000 in assets and $100,000 in liabilities, the extent of your insolvency is $10,000. If a debt of less than $10,000 is canceled, it’s not taxable. But, if the debt is larger than the extent of insolvency, you may have to pay income tax on some of that debt.
The other important exclusion involves bankruptcy. This one is more straightforward. The Internal Revenue Code specifically says that gross income for income tax purposes does not include discharge of indebtedness that occurs in a Title 11 case. That includes both Chapter 7 and Chapter 13 bankruptcy.
In other words, debt discharged in bankruptcy is not taxable income.
A 1099-C May Be Issued in Error
If you receive a 1099-C, don’t assume it’s correct. Creditors sometimes make mistakes. Some may even act in bad faith. The IRS recognizes that a creditor may send a 1099-C not realizing that you qualify for an exclusion.
For instance, a creditor who agrees to accept 50% payment to close out an old credit card account likely won’t have any way of knowing whether you were insolvent at the time. So, you may get a form even if the income isn’t taxable in your specific circumstances.
If that happens, you can complete IRS Form 982. This form lets the IRS know that the amount on the 1099-C (or part of it) should be excluded when calculating your gross income.
Start with Reliable Information about Debt and Taxes
When you’re looking to resolve debt, your best first step may be to speak with an experienced professional who understands the benefits and pitfalls of various approaches.
At Borowitz & Clark, we’ve been helping people in and around Los Angeles get out of debt for decades.
We know how important it is that you have thorough, accurate information before making important financial decisions. That’s why we offer free, no-obligation consultations. Just call 877-439-9717 to schedule yours. Or, if you prefer, fill out the contact form on this page and we’ll reach out to you.
Barry Edward Borowitz is the founding partner of Borowitz & Clark, LLP, a leading bankruptcy law firm that represents clients petitioning for bankruptcy protection under Chapter 7 and Chapter 13 of the bankruptcy code. Mr. Borowitz has been practicing bankruptcy law exclusively for more than 15 years. View his full profile here.