Taxes on Forgiven Debt: The 1099-C Nobody Warns You About

The most common unpleasant surprise in debt settlement arrives the following January in an envelope from a creditor. Forgiven debt is generally taxable income, and a $12,000 settlement can turn into a four-figure tax bill if you did not plan for it.

The general rule

If a lender cancels or forgives $600 or more of debt, it must file Form 1099-C, Cancellation of Debt, and send you a copy. The canceled amount is generally included in your gross income for that year. The logic is that you received money you never repaid, so it functions as income.

The IRS lays out the rule, the exceptions, and the exclusions in Topic No. 431, Canceled Debt, and in far more detail in Publication 4681, which includes worksheets. Both are free.

The exclusion that matters most: insolvency

You do not include canceled debt in income to the extent you were insolvent immediately before the cancellation. Insolvent means your total liabilities exceeded the fair market value of your total assets at that moment.

An example. Right before a creditor forgives $10,000:

Because you were insolvent by $7,000, you exclude $7,000 of the $10,000 and report the remaining $3,000 as income. If insolvency had been $10,000 or more, none of it would be taxable.

Two things trip people up. Retirement accounts count as assets in this calculation even when they are protected from creditors. And the exclusion is not automatic: you claim it by filing Form 982 with your return and keeping a dated worksheet showing every asset and liability. Without that filing, the IRS matches the 1099-C against your return and bills you.

The other exclusions and exceptions

• Bankruptcy. Debt discharged in a Title 11 case is excluded entirely. This is one reason bankruptcy can beat settlement on total cost.
• Qualified principal residence indebtedness, for certain forgiven mortgage debt on a main home, subject to limits and the current expiration rules.
• Qualified farm indebtedness and qualified real property business indebtedness.
• Certain student loan discharges, including death and disability discharges, and discharges under programs where the borrower works in a specified profession. Federal law has also excluded most student loan discharges occurring in recent tax years, so check the current rule for the year of your discharge.
• Gifts and deductible payments. Amounts that would have been deductible had you paid them are excepted, as are debts canceled as a gift.
• Purchase price reductions negotiated with the seller of property.

What to do when a 1099-C arrives

1. Do not ignore it. The IRS receives a copy. Leaving it off your return generates an automated notice.
2. Check the amount and the date. Errors are common, especially when a debt was sold between servicers, and creditors sometimes issue forms for debt that was never actually canceled.
3. Check box 6, the identifiable event code. It tells you why the form was issued, and some codes indicate an event that is not a true cancellation.
4. Run the insolvency worksheet in Publication 4681 for the day before the cancellation.
5. File Form 982 if you qualify for an exclusion. Attach it to the return for the year shown on the 1099-C.
6. Ask the creditor for a corrected form in writing if the amount is wrong, and keep the correspondence.

How this changes the math on settlement

Suppose you settle $30,000 of card debt for $15,000. The forgiven $15,000 is potentially taxable. At a 22 percent marginal rate that is $3,300 you were not planning on, on top of the settlement company's fee. If you were solidly insolvent through the program, the exclusion may erase most or all of that. If your retirement account is healthy and your other assets are substantial, it may not.

This is why the total cost comparison in our guide to debt relief options includes tax. It is also why people whose only significant asset is a retirement account sometimes find that bankruptcy, where discharged debt is never taxable, is the cheaper route.

Get help if the number is large

For a modest cancellation the worksheets are manageable. For a large one, or one involving a home or a business, use a tax professional. Free help exists too: the IRS's VITA and TCE programs prepare returns at no cost for people who qualify by income or age, and the Taxpayer Advocate Service is an independent office inside the IRS that helps when the normal channels stall.

This article is general information, not tax advice. Your facts decide the answer.