Why Do I Have to Pay Taxes on My Cancelled Debt?


Photo by Steve Snodgrass at Flickr.com

This is one of those questions I hear all the time: Why do I have to pay tax on my cancelled debt?  It’s not income so why am I being hit with income tax?


Here’s the situation—you’ve rung up some credit card bills and then you couldn’t afford to pay them off.  You make a deal with the credit card company (or more likely a debt collector) and you agree to pay half of it and they cancel the rest of the debt.  Sounds like a pretty sweet deal doesn’t it?


At least it sounds like a sweet deal until tax time.  What happens then is that you get a statement called a 1099C form which shows that your debt was cancelled and it becomes taxable income to you.   Not so sweet.


But why does it count as income?  This one’s easier to explain with an example.  Let’s say you charged $20,000 worth of stuff.  Let’s say you bought shoes, clothes, a big screen TV and some furniture all on credit.  Or maybe you charged medical bills and food.  It doesn’t matter what you did to acquire the debt.  The results are the same.  Then let’s say you lost your job and couldn’t pay for it.  The credit card company charges interest on the amounts not paid and the bill goes up to $23,000.  You’re in over your head so you get some help from a credit card counselor.  With a loan from your parents you settle the bill for $13,000.  Now you’re free and clear of the debt.


But tax time comes and you get a 1099C stating that you have income of $10,000 which is the amount of your credit card debt that the credit card company forgave.


It’s counted as income, because unlike your parents, the credit card company didn’t make it a gift.  For the credit card company, if they write off your debt, it’s a business expense, and that makes it a deductible business expense to them.  If they were to just give you a gift, that’s not a deductible business expense.


You might be thinking that it’s not fair—but in reality, it’s not only fair, but it’s absolutely necessary.  You see, the credit card company has to report what you charged as income.  Let’s take that TV as an example.  You charge $1,000 for the TV and the credit card company is required to pay $1,000 to the store.  They record the $1,000 as income to the credit card company and then they expense the $1,000 they paid to the store—they haven’t gotten the $1000 from you yet, but since you’re going to pay it, they report the income.  It’s called accrual basis accounting.


But now you’re not going to pay them.  They’re already out the $1,000 they paid to the store for your TV and now they’re not going to get the money that they’ve already had to pay their income tax on.  So when they get to the point that they’re going to cancel your debt—well they have to issue you the 1099C to prove they cancelled the debt and claim their tax deduction.


But why do they add the interest into it?  Once again, they already counted the interest that you should have been paying on that debt as income.


Remember, it takes money to pay for things you want and need.  We pay for those things with our income.  Usually we think of income as wages, but if we buy stuff and then don’t pay for it, that’s also a kind of income to us as well.


For more information on cancellation of debt, see my blog post titled How to Report Debt Forgiveness (1099C) on Your Tax Return.

How to Report Debt Forgiveness (1099C) on Your Tax Return

In my last post I wrote about why debt forgiveness counts as income, but I didn’t explain how to report it on your tax return.  And it’s important that you do report it, or you’ll be getting a nice little letter from the IRS asking you why you didn’t.


First and foremost, if you received a 1099C for cancellation of debt on mortgage interest, you should be reading a different post.  See:  http://robergtaxsolutions.com/2011/11/what-you-need-to-know-if-your-mortgage-debt-is-forgiven/ What I’m talking about here is cancellation of credit card debt.  It doesn’t get treated in exactly the same way as mortgage interest.

Generally, if you receive a 1099C statement, I think you should see a tax professional—and make sure it’s someone who’s worked on debt cancellation issues before.  Not everybody does that.  I once had a client who had called around and I was the 5th person he called before he found someone with debt cancellation experience.  He had started at one of those big box tax places and was told that he owed the IRS $14,000.  That’s when he started thinking he wanted a second opinion.  When I did the return, he actually had a refund.


To be fair, his case was unusual and he managed to catch all the breaks in the tax code—but if he didn’t  have someone who knew the tax code and where the breaks were—well then he would have been paying $14,000 in income taxes that he didn’t really owe.


So how do you report income from cancellation of debt?  Basically, it goes on line 21 of your tax return, in the other income category.  It gets taxed just like anything else that goes on that line—at your regular income tax rate.   That’s what happened with the $14,000 fellow—his preparer put his 1099C income on line 21.  While that’s the correct way to report 1099C income, she had neglected to look for exceptions to see if some (or all) of it might not be taxable.


The two most common exceptions to having your 1099C income being taxed are bankruptcy and insolvency.  In bankruptcy, you’ve actually filed for bankruptcy and your case is either under the jurisdiction of the court and the court has granted a discharge of indebtedness—or is under a plan approved by the court.  Bottom line—you’ve got the legal paperwork to back up your claim that you should be exempt from tax on your cancelled debt.


With insolvency—it means that your liabilities exceeded the fair market value of your assets immediately before the discharge.    Okay, in English.  Let’s say you owed $10,000 on a credit card—that’s a liability.  Your assets included a car, some clothes, a TV, a little cash in the bank that the value of all that totaled $7,000.  Since your liabilities (the $10,000) are more than your assets (the $7,000) you are insolvent by $3,000.  So if the credit card company discharged $5,000 of your debt, you would be able to exclude $3,000 from tax but you’d still pay tax on the $2,000 that you weren’t insolvent on.


To report an exclusion of cancelled debt from taxes, you’ll need to use Form 982.  Here’s a link to that:  http://www.irs.gov/pub/irs-pdf/f982.pdf


If you think you might qualify for the insolvency exclusion, you’ll want to fill out the worksheet located in publication 4681, it’s on page 6.  http://www.irs.gov/pub/irs-pdf/p4681.pdf


Now to be perfectly honest, I’ve really oversimplified this for the sake of brevity.  Many people will have cancelled debt and won’t qualify for any tax forgiveness.   Also, it’s important that you don’t file for tax exclusions if you don’t qualify for them (it’s a type of fraud—you don’t want to go there.)  And it’s quite possible that you can do everything right with the 982 form and you’ll still get a letter from the IRS asking you to confirm something.  (That actually happens quite often so don’t be surprised—it’s pretty normal.)


There are two really important issues you need to learn from this blog post:

  1. 1099C income must be reported on your tax return
  2. You may qualify for some type of exclusion so that some (or maybe even all) of it won’t be taxable

What You Need to Know If Your Mortgage Debt Is Forgiven

Sign Of The Times - Foreclosure

Photo by Jeff Turner on Flickr.com

It’s happening all over the place. Homes are being foreclosed on and banks are forgiving loans. Having your loan forgiven can be a lifesaver, but being taxed on that loan forgiveness can be devastating. There are remedies to help ease the tax burden, but make sure you know the facts so that it doesn’t come back to bite you.

If your debt has been cancelled by the bank, you should receive a document called Form 1099C, Cancellation of Debt. This form also goes to the IRS. It must show the amount of debt forgiven and the fair market value of the property that was foreclosed. Once you get a 1099C, make sure that you check it over carefully. If anything is wrong on that form, you need to go back to the bank to have them change it. The two important numbers you’re looking at are the debt forgiven amount (that’s box 2), and the fair market value of the property at the time of foreclosure (box 7). These figures will be extremely important to you, especially if you have credit card debt or college loan money tied up in your mortgage.

The Mortgage Forgiveness Act of 2007 allows you to exclude up to $2 million of debt forgiven on your principal residence. The limit is only $1 million for a married person filing a separate return. You don’t have to be foreclosed on to exclude debt—you may also exclude debt reduced through a mortgage restructuring. This is really important for people doing a workout with their bank.

To qualify for mortgage forgiveness, the debt had to be used to buy, build, or substantially improve your main home and the mortgage had to be secured by the home. For example: let’s say you bought your home for $250,000 back in 2003. You put $50,000 down and financed the other $200,000. The value of your home was going up, and in 2006 when the balance of your loan was $180,000 you refinanced and took out another $50,000 to pay off credit cards. Times have changed and now you have outstanding debt on your home of $230,000 but the value has dropped to $200,000. The bank forecloses and forgives your debt of $230,000. $180,000 can be written off as mortgage forgiveness because that’s the value of what you used to buy the home, but the remainder will still be taxable to you unless you qualify under some different category to abate the taxes. See where the problem is here? If the home is worth $200,000 when your debt is written off, the whole $180,000 that would have been forgiven is already covered by the value of the home, so really the only debt being written off is the other $30,000 remaining after the fair market value of the home is written off. Because that’s not part of the purchasing debt, that $30,000 is fully taxable, unless you can use of the other exclusions.

If you qualify to exclude your mortgage forgiveness from tax, you’ll need to complete Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (what a mouthful) and attach it to your federal tax return. Here’s a link to the form on the IRS website: http://www.irs.gov/pub/irs-pdf/f982.pdf. If 100% of your debt forgiven was for a mortgage used to buy, build or improve, it’s not that hard to do the forms. If you’ve got any other debt included with your mortgage forgiveness, don’t go it alone.

Debt that was forgiven on credit cards, second homes, rental property, car loans, or business property does not qualify for the principal residence exclusion. The debt might still qualify for a tax exclusion based on another category, like insolvency. There are instructions about claiming the insolvency exclusion on the IRS website, but for that you might want to get professional help with that. You can’t just go, “Oh, I couldn’t pay so I was insolvent.” The paperwork is a little more complicated than that and it tends to get looked at pretty carefully by the IRS. To be honest, I’ve had to help a few people who tried filing 982 forms on their own and wound up getting IRS letters. Personally, I think it’s cheaper to get help from the start and do it right than have to pay someone like me later to straighten out a mess with the IRS.