Of all the surprises that come in the mail for tax season, one of the most dreaded is the 1099-C. The IRS classifies some forgiven debts as a source of income, and thus eligible for taxes. When you receive this form, you must file these forgiven debts on your tax return as income related to the cancellation, settlement, or forgiveness of a previously existing debt. However, as usual, there are exceptions and exclusions to this notification.
How Settlement Can Hurt
Negotiating with your creditors is a good idea. Whether you are negotiating directly with your creditor or they have passed your account on to a debt collection agency, negotiating can reduce payments or even allow you to pay off debt all in one lump sum. You might have thought that was the end of your debt but unfortunately, for debts over a certain amount, that’s not the end of it. Your creditor may report the write-off of that debt to the IRS and you may receive what is called a 1099-C – there may be tax consequences of debt settlement.
How Do I Get a 1099-C?
When you have reached a settlement with your creditors, and they have canceled or forgiven debt over $600, you no longer have to pay that debt to your creditor. However, the creditor will report the forgiveness or settlement to the IRS. The canceled amount is reckoned as income on your tax return.
Under no circumstances should you ever ignore receiving a 1099-C, nor should you leave settled, canceled, or forgiven debts off your tax return? Though you may not have received a notice, your creditor may have provided one to the IRS. By ignoring the form or leaving the information off your tax return, you could be setting yourself up for a tax bill or even an audit notice. It will cost you interest and penalties, probably far in excess of the forgiven debt.
What are Exclusions and Exceptions to a 1099-C?
One of the biggest exceptions to having to pay taxes on a 1099-C is insolvency. You do not have to file for bankruptcy to be considered insolvent. Insolvency means that your debts exceed your assets. As a for instance, if your debts total $40,000 and your assets are worth $35,000, you are insolvent by $5000. If you settle with one of your creditors who agrees to forgive $3000, you do not need to report that on your tax return. Going with the previous scenario, you have assets of $35,000 and debts of $40,000. You negotiate with the creditor who writes off a debt of $10,000. You will need to report $5000 worth of that when you file your taxes.
It should go without saying that forgiven debts are not taxable when they have been discharged in bankruptcy proceedings. Bankruptcy suspends debts and collection actions with the automatic stay, then debts are discharged either through liquidation or reorganization. However, only debts that exist at the time of filing are eligible for this protection.
Other exclusions and exceptions include loans that are classified as gifts from a friend or family member. This money is given with no expectation that it will be paid back either whole or in part. This can be considered a gift for tax purposes and does not need to be reported on your tax return.
Other instances include when the debt is classified as qualified farm debt and is canceled by a qualified authority. Likewise, debts accruing to a qualified principal residence are also excluded as is forgiven interest that would be tax-deductible.
Student Loan Forgiveness and 1099-C Tax Consequences of Debt Settlement
Tax consequences of debt settlement can also include student loan forgiveness or cancellation. First and foremost, the loan must be made by a tax-exempt public entity such as a company or school or come directly from the government. A forgiven student loan is not subject to taxes if it was forgiven or canceled under the provisions of the loan, such as going into a certain profession.
Other student loans can be canceled without penalty if working for certain employers as well. Student loans discharged in bankruptcy are also exempt, but loans discharged for inability to pay fall under normal income tax regulations. For all exemptions, whether or not a student loan, you the taxpayer must provide a filled-out Form 982 to the IRS.
The Importance of Professional Tax Preparation
Using tax preparers versus using CPAs is somewhat akin to using a bankruptcy preparer instead of a bankruptcy specialized attorney. Tax preparers must pass an exam called the Registered Tax Return Preparer Competency Test which covers ethics and the most commonly used 1040 forms.
CPAs must have a bachelor’s degree in accounting or a related field and must complete a national four-part exam administered by the American Institute of Certified Public Accountants. Tax accountants specialize in taxes for businesses and individuals, often those who have a more complex tax picture.
Tax preparers are often hired solely for income tax season and are not required to have an undergraduate degree. If you are dealing with a complex tax picture that includes forgiven debts and other issues, it’s a good idea to go with a tax professional.