Were you aware that cancellation of debt may mean higher income taxes for you? Here’s how to deal with it with the IRS.
RELATED: FAQs On Tax Debt Relief
Guide to Coordinating with the IRS for Cancellation of Debt
1. Understand How the IRS Considers Debt Cancelled
What Is Cancellation of Debt? A debt is cancelled when a creditor decides to forgive a debtor’s tax liability worth $600 and up.
The creditor is required to submit Form 1099-C Cancellation of Debt to the IRS, and give the debtor a copy.
Before taking steps in filing for cancellation of debt, you must first understand the whole process. This helps you negotiate with the IRS more effectively.
If you are a debtor and your creditor forgives your debt, then you must report your cancelled debt in your tax return. The amount of your cancelled debt should be filed under Other Income.
The IRS considers a discharge of indebtedness either on the date an identifiable event occurs or on the date of the actual discharge of debt.
An identifiable event refers to any event that triggers legal cancellation of debt, such as the following:
b. Other judicial debt relief
c. Statute of limitations or expiration of deficiency period
d. Foreclosure election
e. Debt relief from probate or similar proceeding
f. By agreement
g. Decision or policy to discontinue collection
h. Other actual discharge before an identifiable event
2. Verify If You Need to File the Form 1099-C
Reminders for creditors/lenders:
If you are a lender or a creditor, before preparing Form 1099-C, you may first check if you indeed need to file.
You need to file the form if you fall under any of the following:
a. A financial institution mentioned in Sections 581 or 591(a) of the Internal Revenue Code (e.g. domestic bank, building and loan association, savings and loan association, trust company)
b. A credit union
c. Any successor or subunit of the following:
- Federal Deposit Insurance Corporation
- National Credit Union Administration
- Any federal executive agency, including government corporation
- Any military department
- US Postal Service
- Postal Rate Commission
- A subsidiary corporation of a financial institution or a credit union
- Any federal government agency
- An organization whose ordinary course of business is lending money (e.g. finance company, credit card company)
Reminder for debtors:
If you are a debtor, you are only going to receive a copy of this form as filled out by your lender.
3. File the Form 1099-C Cancellation of Debt
What Is the Form 1099-C Cancellation of Debt? If you are a creditor, this is the IRS form that you have to fill out if you have forgiven a loan. It has three parts – Copy A, Copy B, and Copy C.
Copy A is for the Internal Revenue Service Center. Take note that you can only submit the official printed version of Copy A, since the online version is not scannable.
Copy B is to be filled out by the debtor. This section contains the following information:
a. Creditor’s and the debtor’s personal information
b. Amount of tax debt owed
c. Other information about the tax liability
Copy C has similar information as Copy B. This is to be filled out by the creditor.
Reminders for creditors/lenders:
If you are a creditor, after making verifications, you may now proceed to filling out the form.
As a rule for creditors, you need to file a separate Form 1099-C for each debtor that owes you $600 and up.
You also need to file this form regardless of if your debtor is required to state the cancelled debt as taxable income.
Reminders for debtors:
As a debtor, it is important that you review the contents of the Form 1099-C you have received. This is to ensure that the form shows correct information.
Take note that if your creditor is still collecting debt even after filing the form, then the debt is not considered cancelled. This means that you cannot report this cancelled debt as taxable income.
4. Check the Exceptions to Cancellation of Debt Income
This section is only for debtors. Creditors are not required to declare cancelled debt as taxable income.
If you are a debtor, the next step is to check the exceptions to the rule of including cancelled debt as income in your tax return.
Some examples of the exceptions are the following:
a. Debt cancelled by the creditor as a gift, inheritance, devise, or bequest to the debtor
b. Qualified student loans cancelled due to its loan provisions (e.g. working for a given period of time in a given profession)
c. A portion of the debt cancelled due to the debtor’s cash payment
d. Qualified purchase price reduction granted by a property seller
e. Pay-for-Performance Success payments under the Home Affordable Modification program
f. Mortgage expenses related to primary or secondary residence
Exceptions to Cancellation of Debt Income Definition: These allow you to eliminate the whole amount of your tax liability from your income tax return.
5. Take Note of the Exclusions to Gross Income
Also, if you are a debtor, then you may check if your cancelled debt falls under the exclusions to gross income.
Some examples of cancelled debts that qualify as exclusions are the following:
a. Cancelled debt arising from Chapter 11 Bankruptcy
b. Cancelled debt arising from insolvency
c. Debt cancelled due to qualified farm indebtedness
d. Cancellation of debt arising from qualified real property business indebtedness
e. Cancellation of debt due to qualified principal home indebtedness of up to $2,000,000
If you are filing for exclusions, you need to fill out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. Submit this form to the IRS along with your tax return.
Exclusions to Gross Income Definition: As compared to the exceptions earlier mentioned, these exceptions allow you to eliminate only a portion of your tax liability subjected to cancellation of debt.
6. Know When to File the Form 1099-C
Reminders for creditors/lenders:
For creditors, the general rule is to file the Form 1099-C in the same year an identifiable event occurs.
There are just a few reminders for creditors filing the Form 1099-C Cancellation of Debt.
First, if you are a creditor who cancelled debts before an identifiable event happened, then you are required to file for the year you cancelled debts.
Second, you are not required to report an identifiable event if it is related to a debt you have previously reported.
And lastly, you are no longer required to file a corrected Form 1099-C if you receive a debt payment for a debt from previous years.
Reminders for debtors:
As for debtors, once they receive a copy of this form from their creditor, they are required to report this amount. They must enter the amount of their cancelled debt in their annual tax return as taxable income.
7. Prepare Your Tax Return
This section is only for debtors. They need to declare forgiven debt as income in the tax return of the same year of cancellation.
Debtors must include the amount of cancelled debt as Other Income in the Form 1040 U.S. Individual Income Tax Return. Debtors must also attach either Form 1040NR or the Form 1040 Schedule 1 Additional Income and Adjustments to Income.
If there are any exclusions to gross income, then the debtor must also attach Form 982.
8. Be Aware of Your Rights
There are different types of rights that taxpayers can assert when dealing with cancellation of debt. The most common ones are the following: the right to be informed, the right to pay no more than the correct amount of tax, and the right to retain representation.
The Right to Be Informed
When filling or receiving a Form 1099-C, remember that you have the right to know what steps to take to be compliant with the tax laws. You are entitled to ask for clear explanations regarding the tax law and the different IRS procedures.
The Right to Pay No More Than the Correct Amount of Tax
When filing your tax return, remember that you have the right to pay only the amount of tax debt that is legally due of you.
If the IRS wants to adjust the amount of your tax debt, then you have the right to challenge the proposed adjustment. You may file a petition within 90 days upon receipt of the notice.
The Right to Retain Representation
As a taxpayer, you always have the right to have an authorized representative when dealing with the IRS. And if you cannot afford hiring a legal representative, then you may be eligible to ask for assistance from a Low Income Taxpayer Clinic.
9. Reach Out to the TAS and the LITC If You Need More Help
If you are encountering financial hardship due to your tax debts, then you may seek for additional assistance from the Taxpayer Advocate Service (TAS).
The Taxpayer Advocate Service is an organization within the IRS that ensures that all taxpayers are receiving fair treatment.
If you feel that your legal rights are not respected, then the TAS can help you coordinate with the IRS better. The TAS can help you receive faster responses from the IRS, too.
You may also be eligible for legal representation during IRS procedures. You may ask assistance from a certified public accountant, a lawyer, or an enrolled agent from the Low Income Taxpayer Clinic (LITC).
The LITC will provide sufficient information on your taxpayer rights and responsibilities in different languages, to help you resolve your tax issues more efficiently.
Dealing with the IRS regarding cancellation of debt may require different courses of action. The first step is to understand how the whole process goes, and know which measures you can take to protect your rights.
If you are a debtor, always remember to include the cancellation of debt income in your tax return. Otherwise, you will face an IRS audit.
Do you have any tips for filing Form 1099-C? Share your insights below!
If you owe back taxes, visit taxreliefcenter.org for more information on tax relief options.