Form 1099-C and How to Avoid Taxes on Cancelled Debt

Did you know that the IRS considers any forgiven debt as a source of income and that taxes must be paid on that “revenue.” And if you’ve ever settled a debt for less or had debt forgiven completely, you’ve likely received a surprise in the mail coming tax season the Form 1099-C.

A 1099-C reports Cancellation of Debt Income to the IRS. According to the IRS, you must include any cancelled amount (any cancelled, forgiven, or discharged amount) in your gross income (which will be taxed), unless you qualify for an exclusion or exception. For any creditors that forgive you for $600 or more of debt, must file Form 1099-C with the IRS.

Unless there is an exception or exclusion, the IRS looks to have that income included in the tax return regardless of if you have received a 1099-C or not, the creditor is likely to have sent one to the IRS. In the event that you do not acknowledge this information on your tax return, and you creditor has supplied this information, you might get a tax bill.

Insolvency is one of the most prevalent exclusions used by taxpayers to prevent paying taxes on cancelled debt.

Here is how it works:

You create a list of the value of all your assets and a list of all the debts you owe. To the extent your liabilities (debts) exceed your assets, you are insolvent.

Here are a few examples:

Example 1: Your assets are worth $50,000 and your debts are worth $60,000, so you’re $10,000 insolvent. You settle the debt with a creditor who will forgive $9,000. You don’t have to pay tax on that forgiven debt on your tax return as income, since you are insolvent by more than the forgiving debt.

Example 2: Your assets are worth $50,000 and your debts are still worth $60,000, but a $14,000 debt is written off by the creditor. You don’t have to pay tax on $10,000 of the income, but you will have to pay tax on $4,000 as income.