If you thought your money woes ended last year when you settled
that credit card debt, think again.
For many consumers with debt problems, after the debt collector
leaves their lives, the taxman arrives.
Months after successfully resolving credit card debts, consumers
may receive 1099-C "
cancellation of debt
" tax notices in the mail. Why? The IRS considers forgiven or
canceled debt as income. Creditors and debt collectors that
agree to accept at least $600 less than the original balance are
required by law to file
forms with the IRS and to send debtors notices as well. The nearly
6 million taxpayers a year who receive the forms must report that
portion of forgiven debt as "income" on their federal income tax
"A lot of people don't realize they have any tax issues at all
when they are going through this," says Alison Flores, principal
tax research analyst at H&R Block, the tax preparation service.
"They say 'I'm really poor, I'm broke and I can't pay my bills. How
can you consider this income?'"
It is, according to the Internal Revenue Code. For example, a
person with $10,000 in credit card debt who negotiates to pay only
$6,000 of the balance would have $4,000 in forgiven debt income.
That $4,000 must be reported as "other income" on Line 21 of the
1040 tax form. Depending on the amount of debt forgiven, the
taxpayer's income level, deductions and other factors, the consumer
could face a sizable tax bill come mid-April.
Surprise tax problem
The problem: Many consumers have no clue what the 1099-C forms are,
and some may be trashing the cancellation of debt notices because
the forms are sent by creditors or debt collectors with whom they
thought they no longer had business. Still others are not filing
the 1099-Cs with their federal income tax returns -- putting
taxpayers at risk for IRS audits, penalties and fines. Consumer
credit counselors and tax attorneys say few consumers are aware of
the tax implications of settling to pay a lesser amount than they
owe in credit card debt.
"It's truly something that consumers need to be aware of, as
they are often blindsided by it," says Gail Cunningham, spokeswoman
for Credit Counseling
, a nationwide group of nonprofit credit counseling agencies. "Just
when they think the debt monkey is off their back, here comes the
The number of "surprise" tax problems grew as the amount of bad
debt shot up during the recession, and has lingered since.
According to the IRS, the number of 1099-C cancellation of debt
forms filed with the federal government by creditors and debt
collectors saw a fivefold increase from 2003 to 2012 (see
). Most of the increase took place following the recession. The IRS
received fewer than 1 million forms in the calendar year 2003 and
5.4 million in 2012. The projected number for 2014 is 5.7
million, and the IRS expects to get 7 million debt forgiveness
forms in 2022.
Negotiating with creditors, debt collectors and debt buyers to
pay a fraction of the amount owed is a common practice in the
industry, often accomplished through third-party agents such as
consumer credit counselors or
debt settlement specialists
"Debt buyers are willing to negotiate a discount, sometimes,
depending on a person's circumstances, at a very significant
discount off the entire balance, to settle the debt," says Donald
Maurice, general counsel for the 600-member DBA International, a
trade group of companies that buy and sell portfolios of debt from
banks and other creditors.
Not all forgiven debt taxable
Consumers who receive the 1099-C cancellation of debt forms should
immediately take them to a tax preparer or tax adviser, experts
"Make sure your tax preparer understands the rules related to
these type of activities," says Mark Steber, chief tax officer for
Jackson Hewitt tax preparation service. "Ask to talk to an office
manager. Tell them 'I need to see someone who understands this type
Taxpayers may qualify for one of several exclusions that allow
them to reduce taxable income from canceled debts. If the
exclusions apply, they must file an IRS
in addition to the 1099-C.
"Theoretically, you have [taxable] income if you don't meet one
of the exceptions," says Connecticut tax attorney Eric L.
6 exceptions to paying tax on forgiven debt
include debts discharged during bankruptcy and debts of consumers
who are insolvent (meaning their liabilities exceed their assets)
before the cancellation of debt. However, the exclusion applies
only up to the amount by which consumers are insolvent. That means
if $5,000 in debts were forgiven and liabilities exceeded assets by
$2,000, then the $2,000 would be not be counted as taxable income.
"The remaining $3,000 would be reported under other income," says
H&R Block's Flores.
Homeowners exclusion ends
Homeowners who default on mortgage loans on their primary
residences may also qualify for an exclusion from income on
foreclosures under the
Mortgage Forgiveness Debt Relief Act
, which took effect in 2007 to help homeowners caught in the
mortgage crisis. This provision applies to up to $2 million in
mortgage debt forgiven in calendar years 2007 through 2013. This
exception had been scheduled to expire at the end of 2012, but was
extended by Congress.
Steven M. Piascik, a certified public accountant and president
of Piascik & Associates in Richmond, Virginia, warns, "If you
use the proceeds from a home equity line of credit to pay off
credit card debts, or for something other than making improvements
to your home, that portion will not qualify for the $2 million
However, if you used a credit card to pay for home improvements
on your primary residence and can prove that the charges were
exclusively for home improvements, you may be able to claim an
exemption from mortgage-related debt forgiveness income for that
Much of the surprise element of the 1099-C cancellation of debt
forms could be eliminated, say tax preparers, if all creditors and
debt buyers routinely informed consumers that there could be tax
ramifications when settling debts for discounted amounts.
"The bank doesn't tell you," says Green, the Connecticut tax
attorney. "From the bank's perspective, it's not their job to give
Says Maurice from the debt buyers group: "There is no current
law that says that a debt buyer must disclose that a 1099-C would
be forthcoming after the settlement of debt."
The National Taxpayer Advocate Service has cited confusion and
inadequate communication about 1099-Cs in its annual report to
Congress on IRS improvements needed to help consumers. The taxpayer
advocate's office has published
YouTube videos in an effort to demystify the 982 tax
needed to claim an exemption from taxes on forgiven debt.
Another potential problem: receiving a 1099-C before the debt is
actually paid off. According to Lauren Saunders, managing attorney
for the National Consumer Law Center, creditors have sent
cancellation of debt forms to consumers at the point that the
credit card issuers charged off the debt and sold it to debt
buyers. "The consumer is potentially liable both for taxes on
supposedly forgiven debt while continuing to be liable for the
debt," Saunders says. "We've had calls about that situation. Seems
like you can't have it both ways: Either you forgive it or sell it
but not both."
A consumer in this situation should contact the creditor
who filed the 1099-C for clarification, said Flores of H&R
Block. You can also check your credit report to see if the debt is
still marked as outstanding -- but don't expect that to carry much
weight with the tax collector. "The IRS works with data
matching -- if they get a copy of a 1099-C, they'll look for that
(income) on the tax return," she said. "As far as the IRS is
concerned, that is what they know." If the creditor does not
rescind the 1099-C, it will be necessary to use the IRS dispute
process to show that the debt has not been canceled.
The federal taxpayer advocacy agency cited the gap in creditor
reporting requirements as
one of the most serious IRS consumer problems
in its 2010 report to Congress. "A creditor that issues a Form
1099-C is not necessarily canceling a debt, yet the IRS assumes
that Form 1099-C reflects taxable income to the debtor," according
to the report. The taxpayer advocate recommended that the IRS
revise the 1099-C form to include a box for creditors to indicate
whether a debt was actually canceled. The IRS responded that it
would consult its legal advisers, but forms have yet to
'Be aware of it and prepare for it'
The bottom line on 1099-Cs, says tax attorney Green: "Be aware and
prepare for it. When you receive that form, go immediately to a tax
adviser. Don't ignore it. That has real dollars and cents
Steber, from Jackson Hewitt, warns that the IRS is more advanced
at tracking taxpayers' income. "There is an increased likelihood
that if you had one of these events that the IRS knows about it,"
he says. "The IRS tracks it back. The IRS is quick to catch up with
the person who, for whatever reason, left that [1099-C] off of
Taxpayers who might have moved and didn't receive their 1099-C
notices in the mail from creditors can't count on ignorance as a
defense: "They will catch up with you," Steber says.
Beware growing tax fraud threat
Canceled debt exemption little used
Canceled debt tax notices riddled with problems