The most feared and least understood document ever published by the IRS – quite the accomplishment considering the competition– is Form 1099-C Cancellation of Debt.

This form is sent to people who were so deep in debt, even their creditors agreed to give them a break and either reduce or cancel their debt altogether. Think foreclosures, short sales, credit card debt settlements and similar debt consolidation methods.

Only that in the eyes of the IRS the cancelled debt has not disappeared. Instead, it has transformed into a new source of taxable income: debt income — the ultimate oxymoron. Who said tax collectors don’t have a sense of humor?

Why Do You Have to Pay Taxes on Cancelled Debt?

If you have received a IRS Form 1099-C, your first reaction was probably disbelief. It does seem counterintuitive to have to pay taxes on cancelled debt.

The IRS’ response is that when you borrowed that money you did not have to pay taxes on it because you were bound by contract to pay it back. If you had repaid the debt, it would have been as if you had never really owned the money. However, when a creditor releases you of debt, you are in effect receiving a payment you did not return, which is the very definition of income.

On the question of why the IRS thinks you will be able to pay taxes on a debt you could not afford to settle in the first place, I have no comeback.

1099-C Disputes

Creditors who cancel a debt of $600 or more are required by law to report the debt discharge to the IRS by filling in a 1099-C and sending a copy to the debtor.

This is worth repeating. Creditors, not the IRS, send 1099-Cs. They can write whatever they want on that form. Therefore, if you do not agree with the amount listed on the form, you need to contact the creditor.

Maybe the debt was discharged long ago during a bankruptcy; or the debt amount is correct but the fair market value of the debt’s security is way off. It could be you have no record or recollection of a debt cancellation. Whatever the issue is, you need to contact the creditors and try to resolve the discrepancy.

The address and telephone number of the creditor should be on the top left box of the form. If it turns out the creditor made a mistake, they can issue a new 1099-C with the correct information.

Discrepancies and Tax Audits

It is worth highlighting that the IRS also receives a copy of the information on your 1099-C. If you fail to declare taxable debt income, you may have to pay an additional negligence penalty as well as interest on your taxes, as well as other sanctions.

If you do not agree with the debt income amount and you cannot resolve the issue with the creditor, things get tricky. You can make a note in your tax return. However, a word to the wise, discrepancies between your tax return and 1099-C forms, even when accompanied by explanatory notes, are tax audit magnets. Don’t be shocked if the IRS wants a closer look at your accounts.

Thank Goodness for Exceptions and Exclusions

Not all types of unpaid debt are taxable, and you may qualify for exclusions that could either reduce or even cancel your tax liability.

IRS Form 4681 discusses the subject of debt income exceptions and exclusions in detail.  If you qualify for any of these exceptions, you need to fill in ad attach IRS Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness to your tax return.

Exceptions and Exclusions

• Gifts. Debts canceled as a gift, a bequest or as part of an inheritance are generally not considered income.
• Student loans. Student cancelled in exchange for working for certain employers. For instance, the Nurse Corps Loan Repayment Program that pays up to 60% of the student loans of nurses willing to serve in hospitals and clinics in some of America’s neediest communities.
• Bankruptcy. Debts canceled during a title 11 bankruptcy are excluded from gross income. To prove debt income reported in a 1099-C was discharged as part of a bankruptcy, complete and attach Form 982 to your tax return and make sure you check the box on line 1a.
• Insolvency. If your debts were cancelled due to insolvency – because your debts were greater than your total assets – some or even all of your cancelled debt may not be taxable. For instance, if your total assets amounted to $10,000 and your total debt was $15,000, you may not have to pay taxes on debt income of $5,000 or less. If you were insolvent when your debt was forgiven, check box 1b in Part 1 of Form 982 and attach it to your tax return. Form 982 includes an insolvency worksheet you can use to determine how much of the debt you can exclude from your debt income.
• Principal Residence. If the cancelled debt was on your principal residence, you can exclude up to $2 million of the debt, or $1 million if married filing separately. Mind you, this does not apply to investment or vacation homes.

Don’t Panic, You May Be Exempt

If you receive a 1099-C Form, try not to panic. You may be exempt from paying taxes on the debt income, and if not, you probably can exclude a big chunk of it.

However, negotiating debt income matters with creditors and the IRS is a complex matter and hiring a tax professional with experience in debt income cases may save you a lot of cash, time and grey hairs in the end. Consider hiring a qualified tax advisor with experience in debt income matters. She can determine whether your cancelled debt is taxable; help you calculate how much you can exclude; and manage negotiations with creditors.

Photo: Getoutofdebt.org