1099-C Explained: Avoid Taxes on Canceled Debt
While no longer owing a debt is nice, the 1099-C that accompanies a cancellation can come as an alarming surprise. The good news is that many debtors released from a debt obligation may qualify for an exclusion from gross income or an exception.
Even if you expected your creditor to cancel your debt, you may be surprised to receive a 1099-C tax form in the mail. This form is the government’s way of calling for what you owe in taxes on the canceled debt.
If you have canceled debt and have received a tax form stating you owe money, it’s important to understand your options for avoiding the tax burden.
Although there are many strategies that can work for getting out of debt, there are sometimes circumstances that make it nearly impossible. In this case, a debt cancellation may be the best solution.
A debt cancellation is when a creditor effectively forgives the debt, relieving the debtor of the balance owed. Borrowers can achieve debt forgiveness in several ways, such as through bankruptcy or a debt relief program.
Regardless of the reason for the debt cancellation, 1099-C form may arrive in the mail shortly after a debt is released, which can catch some people off guard. Most borrowers don’t realize that the IRS views canceled debt as income. The purpose of this form is to inform recipients of the tax liability that they now owe.
Here, we break down just what a 1099-C is and explain how you can avoid taxes on canceled debt.
What is a 1099-C?
Receiving a 1099-C in the mail can be both confusing and terrifying if you didn’t realize you owe taxes on canceled debt, according to Gerri Detweiler, Education Direction for Nav and credit expert.
“The IRS will automatically include the debt in your taxable income unless you can demonstrate otherwise,” Detweiler says. The 1099-C form lays out the creditor’s information, the debtor’s information, and the date of the canceled debt. The form also indicates the total amount of the debt, if interest was included, and if the debtor was personally liable for repayment before cancellation. Without a qualifying exception, the amount listed on a 1099-C is reportable as income on the debtor’s tax return.
A 1099-C is generally issued to borrowers when more than $600 in debt is canceled.
Debt may be considered canceled during settlement for less than the amount owed, in bankruptcy, and when debt is forgiven.
Also, a vehicle possession that only partially satisfies an outstanding auto loan, mortgage debt remaining after a foreclosure, or short sale that is ultimately discharged by the creditor all may also result trigger a 1099-C.
What to Do When You Receive a 1099-C
While receiving a 1099-C for canceled debt may come as an overwhelming surprise, ignoring it could mean you have no recourse for avoiding taxes.
“The first step is to not freak out, because you may be able to minimize or eliminate the tax debt,” Detweiler says. Review the form for accuracy, including the credit details, the amount listed, and the date of the event. Then, recognizing the specific circumstances that may qualify for you an exclusion or exception on paying taxes for canceled debt is crucial. Here’s what you need to know about qualifying exclusions and exceptions.
Exclusions on Canceled Debt
Several exclusions on canceled debt can reduce how much you may owe in additional tax liabilities. Essentially, under the exclusions, some portions of your debt are not considered part of your gross income. These include:
- Any debt canceled in a Title 11 bankruptcy case
- Debt canceled during insolvency
- Qualified farm indebtedness cancellation
- Real property business indebtedness cancellation
- Principal residence indebtedness cancellation
“The insolvency exclusion is the most frequently used… as it allows you to eliminate taxes for forgiven debt to the extent your liabilities exceeded your debts before the debt was forgiven,” Detweiler said.
Importantly, if any exclusion applies, you may not be able to take certain credits or carryovers for that tax year. However, using one of these exclusions can be tremendously helpful in reducing your tax burden on canceled debt.
Exceptions on Canceled Debt
Exceptions on canceled debt differ from exclusions but they also reduce your tax burden. These include:
- Any amounts canceled as gifts, bequests, devises, or inheritances
- Qualified student loan debt canceled under a provision based on working in a certain profession for certain employers for a set period of time
- Education loan repayment and forgiveness programs related to those providing health services in certain regions
- Canceled debts that would be deductible if it was paid
- A purchase price reduction given by the seller of a property to the buyer
- A pay-for-performance success payment that reduces a principal balance on a home mortgage under the Home Affordable Modification Program
Amounts that qualify for any of these exceptions are not included in taxable income.
How to Get a 1099-C Exception or Exemption if Your Debt Qualifies
If your canceled debt qualifies for one of the exceptions or exclusions listed above, you can take certain steps to ensure it’s not included in your taxable income.
“Instructions and a worksheet in IRS publication 4681 provide guidance on how to submit a request for an exclusion or exception. IRS Form 982 is used to explain to the IRS which circumstance you are claiming,” as Detweiler said.
Once you complete the forms, send them directly to the IRS. Try to send the forms with tracking and keep records of the information sent. Each both the publication form and claim form can be found online.
The Bottom Line
Debt cancellation can impact any individual’s financial life at any time, for a variety of reasons. While no longer owing a debt is beneficial to your financial health, the 1099-C that comes with a debt cancellation can come as an alarming surprise.
The good news is that many debtors released from a debt obligation may qualify for an exclusion from gross income or an exception. Using these can make a significant difference in successfully reducing or eliminating taxes owed on canceled debts.