They can come out of the blue, reminding you of debts you thought were finally resolved. Isn’t that the point of debt settlement, after all? Unfortunately, the debt you’ve been forgiven is considered income by the Internal Revenue Service (i.e., you’re expected to pay taxes on it). Thus the purpose of the 1099-C, a form creditors are required to file on forgiven debts of $600 or more so that the IRS knows how much to bill you for. Fortunately, there is also a system in place to protect the rights of taxpayers. Under certain circumstances, you may owe nothing.
Don’t ignore it. If you received a copy of a 1099-C in the mail, so did the IRS. Ignoring it suggests to the IRS that you are trying to avoid paying the tax you owe. In the best case scenario, they take what you owe out of your income tax return, or they send you a bill. Worst case, you get audited.
Validate the debt. If you’ve been through the debt settlement process, you’re probably well aware that creditors can make mistakes. The information on a 1099-C is no exception. Look over the form carefully and request validation of the debt from the creditor. If they cannot prove you ever owed this debt, you can provide documentation of such to the IRS so that you can be relieved of your tax liability.
Steps Three and Four
Determine if you qualify for an exclusion or an exception. Such qualifications mean the settled debt amount should not be counted toward your gross (taxable) income.
You may qualify for an exclusion in the following circumstances:
- Cancellation of qualified principal residence indebtedness.
- Debt was canceled in a Chapter 11 bankruptcy.
- Debt canceled due to insolvency.
- Cancellation of qualified farm indebtedness.
- Cancellation of qualified real property business indebtedness.
You may qualify for an exception in the following circumstances:
- Amounts specifically excluded from income by law such as gifts or bequests.
- Cancellation of certain qualified student loans.
- Canceled debt that if paid by a cash basis taxpayer is otherwise deductible.
- A qualified purchase price reduction is given by a seller.
Note, the two most common circumstances under which taxpayers qualify are exclusions for either debt canceled in a Chapter 11 bankruptcy; or debt canceled for insolvency, meaning it is proven the taxpayer’s liabilities exceed their assets.
Fill out and submit Form 982 to the IRS. It is on this form that you will indicate why you qualify for an exclusion or exception.
Consult a tax professional if you have any doubt as to how to fill out Form 982 and/or whether you qualify for an exclusion or exception.
Pay the tax, if need be, but only after exhausting all of your other possibilities, as discussed with a tax professional.