Tax Consequences of Cancelled Debt

Written By: Chris Waclawik

Individuals who have a debt cancelled or forgiven can find themselves in for an unpleasant surprise when tax season arrives. Generally, a debt that has been cancelled or forgiven by a lender must be included as income on that year’s tax return just as if the money had been earned directly.  However, there are ways for most taxpayers to exclude some if not all of that cancelled debt from taxable income. The prudent financial counselor needs to make clients aware of the potential to receive a 1099-C, Cancellation of Debt, particularly if the credit report shows very old debts.

When reviewing a credit report with a client, it’s commonplace to see credit reports chock-full of old debts that have had no activity in several years and may soon be reaching the time when they no longer will show up on a credit report. However, just because a debt no longer shows up on a credit report or exceeds the statute of limitations does not mean the debtor has heard the end of it. Creditors appear to have no time limit within which they are required to cancel a debt and issue a 1099-C to the debtor.  A 1099C can show up in the mail long after the underlying debt ceases to appear on the debtor’s credit report, taking the debtor by complete surprise.

First, taxpayers need to be aware that anytime that a debt is cancelled, whether it is credit card debt, an unpaid medical bill, home foreclosure, or any other type of debt, the lender is required by the IRS to report the amount of the cancelled debt to both the taxpayer and the IRS on Form 1099-C. In the 2014 instructions for Form 1099-C, the IRS specifies that a creditor is required to report the cancelled debt if the principal amount, exceeding interest and administrative costs, exceeds $600. If a 1099-C is issued and the cancelled debt is not reported on that year’s tax return, the IRS will send out a letter to the debtor for the unpaid taxes, interest, and in some cases a penalty.

Once the debt has been cancelled and a 1099-C has been received, there are a number of ways that a taxpayer can avoid having to include it in income on a tax return. The three most common methods that follow are described in detail in IRS Publication 4681:

1. Bankruptcy—Any debts discharged through bankruptcy are not considered taxable income and can be excluded.
2. Insolvency—If a taxpayer has more debts than assets at the time the debt is cancelled, debts are not taxed up to the extent of that insolvency.  For example, the bank that holds Jim’s credit card cancels $10,000 worth of credit card debt.  Immediately before his debt is cancelled, his assets are worth $15,000, which represents fair market value of his car, furniture, and other personal items. His debts include the $10,000 worth of credit card debt that was cancelled and an $11,000 car loan which totaled $21,000.  In this case, he has a net worth of -$6,000, which is the difference between $15,000 assets – $21,000 liabilities. Jim can exclude $6,000 of the cancelled debt and only has to report $4,000 in income.
3. Sale of a primary residenc—In response to the subprime mortgage crisis, Congress passed the Mortgage Forgiveness Debt Relief Act of 2007.  This allowed homeowners to exclude from taxable income the cancelled debt left after a foreclosure, loan modification, or a short sale of a primary residence. This expired on December 31st, 2013 and was extended retroactively through 2014 when Congress passed the Tax Increase Prevention Act of 2014 on December 16th, 2014. Whether this legislation will be extended again remains to be seen.

Even if Congress fails to act, most debtors who have mortgage debt forgiven will still qualify for the insolvency exception. It is noteworthy that assets in a 401(K) or IRA are included as assets in the insolvency calculus, and the amount of the forgiven debt is likewise included.  Insolvency is measured as of the date the 1099-C was issued.

Financial professionals are in a unique position to alert clients that any old debts may be forgiven and resurface as income in the form of a 1099-C. Cancelled debt that is being excluded using one of the above methods must be reported on IRS Form 982 and attached to the tax return.

Because these provisions are complicated and change often, clients who receive a 1099-C should find assistance from a tax professional to ensure that it is correctly reported and excluded to prevent the stress of unpaid debts from turning into an unexpected tax bill.

More Readings on Cancelled Debt

For additional information, log on to the following:

• http://www.irs.gov/Individuals/The-Mortgage-Forgiveness-Debt-Relief-Act-andDebt-Cancellation
• https://www.congress.gov/113/bills/hr5771/BILLS-113hr5771pcs.pdf
• http://www.irs.gov/pub/irs-pdf/f982.pdf
• http://www.irs.gov/pub/irs-pdf/i1099msc_14.pdf
• http://www.irs.gov/publications/p4681/index.html