Perhaps 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. Form 1099-C 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. The issue is 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.
Why Do You Have to Pay Taxes on Cancelled Debt?
If you have received an IRS Form 1099-C, your first reaction was probably disbelief. It does seem counterintuitive to have to pay taxes on cancelled debt. The IRS’s 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 a liability, you are in effect receiving a payment you did not return, which is a definition of income.
Creditors who cancel a debt of $600 or more are required by law to report the amount of debt discharged to the IRS by filing a 1099-C and sending a copy to the debtor. It’s worth mentioning that these creditors can make errors on these forms. Therefore, if you do not agree with the amount listed on the form, you will need to contact the creditor and request a corrected form. 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 report taxable debt income when you file your taxes, you may have to pay an additional negligence penalty, 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. If you find yourself in this scenario, you should prepare yourself and expect the IRS to want a closer look at your accounts.
Exceptions and Exclusions
Not all types of unpaid debts are taxable, and you may qualify for exclusions that could either reduce or even cancel your tax liability. IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (For Individuals), discusses the subject of debt income exceptions and exclusions in detail. If you qualify for any of these exceptions, you need to fill in and attach IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to your form 1040.
Some examples of exceptions and exclusions include:
- Gifts: Debts canceled as a gift, a bequest or as part of an inheritance are generally not considered income.
- Student Loans: Student loans cancelled in exchange for meeting certain requirements, student loan repayment help programs, student loan cancellation from 2021 through 2025.
- 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 $750,000 of the debt, or $375,000 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 stress. Consider hiring a qualified tax advisor with experience in debt income matters. They might be able to determine whether your cancelled debt is taxable, how much you can exclude, and how to manage negotiations with creditors. Optima Tax Relief is the nation’s leading tax resolution firm with over $1 billion in resolved tax liabilities.
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Dealing with debt can be a stressful and overwhelming experience, but imagine finally having a weight lifted off your shoulders when a creditor cancels or forgives a portion of your outstanding debt. While the relief might be immense, it’s essential to understand that canceled debt can have significant tax implications. Many individuals are unaware that in certain circumstances, forgiven debts can be considered taxable income by the IRS. In this article, we will review the concept of canceled debt and its potential tax implications.
Understanding Canceled Debt
Canceled debt, also known as forgiven debt, occurs when a creditor decides to release a borrower from the obligation to repay a portion or the entirety of a debt. This situation typically arises when borrowers face financial hardships, negotiate debt settlements, or undergo bankruptcy proceedings. The canceled debt can encompass various types, including credit card debt, mortgages, personal loans, or business debts.
The Tax Consequences of Canceled Debt
The IRS generally considers canceled debt as taxable income, which can come as a surprise to many borrowers. From the IRS’s perspective, the forgiven debt is akin to receiving cash or other income, thus making it subject to taxation. This means that although you no longer have to repay the debt, you might have to pay taxes on the amount forgiven in the year it was canceled.
Exceptions to Taxable Canceled Debt
Fortunately, the IRS provides certain exceptions that can exclude canceled debt from being taxable income in specific situations. Some of these include:
- Bankruptcy: Canceled debt discharged through a bankruptcy proceeding is generally not taxable. This exclusion applies to both Chapter 7 and Chapter 13 bankruptcies.
- Insolvency: If you were insolvent immediately before the debt cancellation, meaning your liabilities exceed your assets, the canceled debt may not be taxable. You must file IRS Form 982 to claim this exclusion.
- Qualified Principal Residence Indebtedness: The Mortgage Forgiveness Debt Relief Act of 2007 allows taxpayers to exclude up to $2 million ($1 million for other filing statues) of forgiven mortgage debt on their primary residence for years 2007 through 2020. This act also applies to discharged debt in 2021 as long as there was a written agreement in place in 2020. In addition, The Consolidated Appropriations Act (CAA) of 2020 excludes qualified canceled mortgage debt, up to $750,000 for married couples and $350,000 for other filers, from taxable income for tax years 2021 through 2025.
- Some Student Loan Forgiveness: Some student loans are canceled after working in a certain profession for a specified number of years. Some student loan forgiveness in the years 2021 through 2025 are not considered taxable income.
Tax Reporting and Documentation
For canceled debt that qualifies as taxable income, the creditor is required to report the forgiven amount on Form 1099-C, Cancellation of Debt. Form 1099-C reports all eligible canceled debt of $600 or more per occurrence. Taxpayers should note that if they had debt under $600 that was canceled, it still needs to be reported as income, even if they don’t receive a 1099-C. The debtor should receive this form from the creditor and must include the forgiven debt as part of their annual income when filing taxes, as long as it’s not an excluded debt. However, if your debt does fall under one of the IRS’s exclusions, you should still file your return with Form 1099-C to acknowledge it. In addition, if you receive Form 1099-C after filing your tax return, you should file an amended return and include the Form 1099-C. Not doing so may raise some red flags with the IRS that can result in a tax audit. Finally, if there is an error on your Form 1099-C, you should contact the creditor immediately to request a corrected version.
Remember, you should always consult the help of a knowledgeable tax professional if you are unsure about your tax situation.
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Now that we know the basics of IRS Form 1099, we can take a closer look at the different types of 1099s you can receive. Remember, if you received any income outside your employer, you might receive a 1099. While most types of Form 1099 are not commonly received, there are a handful that you are likely to come across at some point. Here’s an overview of the different types of Form 1099.
1099-MISC: Miscellaneous Income
The 1099-MISC is an IRS form used to report $600 or more in miscellaneous income that you received during the tax year. Some examples of payments that require a 1099-MISC form include rent, prizes and awards, medical and health care payments, crop insurance proceeds, attorney payments, and more.
1099-NEC: Nonemployee Compensation
The 1099-NEC form is used to report non-employee compensation, including independent contractors, freelancers, sole proprietors, and self-employed individuals. If you received $600 or more in non-employee compensation during the tax year, you should receive a 1099-NEC. This form is used to report payments made for services rendered, such as consulting fees, professional services, and other types of compensation.
1099-INT: Interest Income
Form 1099-INT is used to report any interest income you earned during the year. If you earned more than $10 in interest income, the financial institution is required to send you and the IRS a Form 1099-INT. Interest income can include any earned from high-yield savings accounts, U.S. savings bonds, municipal bonds, and more.
1099-DIV: Dividends and Distributions
Form 1099-DIV is used to report dividends and distributions that are paid to you during the tax year, as well as any federal income tax withheld. This can include ordinary dividends, which are paid out of a company’s earnings and profits, qualified dividends, capital gain distributions, and non-dividend distributions. It does not include any dividends that you accrued through tax-sheltered retirement accounts. You will typically receive a 1099-INT if you received at least $10 in dividend income.
1099-K: Payment Card and Third-Party Network Transactions
Form 1099-K is meant to track payments made through third-party networks, such as PayPal or Venmo. For the 2023 tax year, you would receive a 1099-K if you earned at least $600 in payments. Since 1099-Ks report gross income, you should be sure to deduct any expenses you had to use third-party payment networks to receive payments.
Other Types of 1099s
- 1099-A, Acquisition or Abandonment of Secured Property: reports foreclosures on properties. You may be liable for capital gains tax and income tax for any unpaid foreclosed mortgage balances.
- 1099-B, Proceeds from Broker and Barter Exchange Transactions: reports the sale of stock, bonds, and other securities through a broker, as well as barter exchange transactions. These transactions must be reported even if you had a loss or broke even.
- 1099-C, Cancellation of Debt: reports discharged, forgiven, or canceled debt. This can include your property foreclosure or forgiven credit card debt but typically excludes debt discharged in bankruptcy. You will need to claim the amount reported on your 1099-C as taxable income.
- 1099-CAP, Changes in Corporate Control and Capital Structure: reports the amount of cash, stock, or property received after a significant change in the company’s control or capital structure.
- 1099-G, Certain Government Payments: reports payments you received from government agencies, including unemployment, tax refunds, taxable grants, and more.
- 1099-H, Health Coverage Tax Credit (HCTC) Advance Payments: reports any advance payments of qualified health insurance payments you received. If you qualify for trade adjustment assistance (TAA), alternative TAA (ATAA), reemployment TAA (RTAA), or Pension Benefit Guaranty Corporation (PBGC), you might see this form.
- 1099-LTC, Long Term Care and Accelerated Death Benefits: reports payments made under a long-term care insurance contract. This includes accelerated death benefits, or benefits received before death because the policyholder has been deemed terminally ill by a doctor. The amount shown on the 1099-LTC are generally tax-free but are required to be reported to the IRS.
- 1099-LS, Reportable Life Insurance Sale: reports the amount paid to you from a life insurance sale.
- 1099-OID, Original Issue Discount: reports $10 or more of income received when bonds, notes, or certificates of deposit (CDs) are sold at a discount from their maturity value.
- 1099-PATR, Taxable Distributions Received from Cooperatives: reports at least $10 in patronage dividends and other distributions from a cooperative (co-op) in the prior year.
- 1099-Q, Payments from Qualified Education Programs: reports total withdrawals from qualified tuition programs (QTPs) like 529 plans or Coverdell educational savings accounts. This amount may be taxable, depending on how the funds were used.
- 1099-QA, Distributions from ABLE Accounts: reports distributions from an Achieving a Better Life Experience (ABLE) Account for special needs individuals with a disability. These funds are not taxable if you used them to support a disabled individual.
- 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.: reports distributions from annuities, profit-sharing plans, retirement plans, IRAs, insurance contracts, or pensions. You should consult with a tax professional about whether you will owe tax on these distributions.
- 1099-S, Proceeds from Real Estate Transactions: reports the sale or exchange of real estate. If the property was your primary residence for two of the five years before the sale, then up to $250,000 of the profit is exempt from taxes. This amount increases to $500,000 for married couples filing jointly.
- 1099-SA, Distributions From an HSA, Archer MSA, or Medicare Advantage MSA: reports distributions made from a health savings account (HSA), Archer Medical Savings Account (Archer MSA), or a Medicare Advantage Medical Savings Account (MA MSA). Distributions can be taxable if they were used to pay for qualified medical expenses, if they were not rolled over in some cases, if excess contributions were made, and other scenarios. You should consult with a tax professional about whether you will owe tax on these distributions.
- 1099-SB, Seller’s Investment in Life Insurance Contract: reports the sale of a life insurance policy like the 1099-LS. The difference is that the original issuer of the policy files a 1099-SB after they receive the 1099-LS. You should consult with a tax professional if you receive either of these forms.
Tax Help for Those Who Receive 1099s
The list of 1099s and the accompanying filing requirements can quickly become very complicated. You should always consult with a tax professional if you are unsure about your tax filing requirements. Remember, even if you do not receive a 1099 for income earned, it’s still your responsibility to include it in your taxable income. Not doing so can be a major red flag to the IRS and can result in an audit. Optima Tax Relief has over a decade of experience helping taxpayers with tough tax situations.
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