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Can taxes apply to canceled debts?

In Arizona as in the rest of the U.S., the IRS requires creditors to disclose all canceled debts of $600 or more on a 1099-C tax notice. In most cases, the agency considers canceled debt a form of taxable income, so people failing to report such debts on their income tax returns could receive an audit that could result in additional taxes, penalties and interest. Those who receive these notices may want to speak with a tax professional before filing their income taxes to discuss their options.

The IRS gives taxpayers the right to file a Form 982 to reduce or eliminate their tax obligations related to the debt cancellation in some cases. It allows these reductions for a few reasons, including insolvency and Title 11 cases. From 2007 until the end of the 2013 calendar year, an exclusion was also available for up to $2 million in mortgage debt that lenders forgave during that time because of the mortgage crisis. Debts discharged in bankruptcy, notably, are also exempt from tax obligations.

The law does not require debt buyers or debt collectors to disclose the fact that a 1099-C and tax obligations on the amount that they forgive could result from a settlement. This means that some taxpayers may be unaware that they need to pay taxes on this amount until either the 1099-C form arrives or the IRS initiates an audit. In some cases, a company may issue a 1099-C form without the debtor paying anything. This sometimes happens when the company sells the debt to another company.

When facing large amount of debt, understanding all of the benefits and consequences that each option provides can be very important. An attorney could explain how each option works, including how much the debtor must pay and how it affects the debtor's credit rating. Since each case is unique, every person should decide which option best suits his or her individual situation.

Source: CreditCards.com, "1099-C surprise: IRS tax follows canceled debt", Connie Prater, November 03, 2014

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  • NACA | National Association of Consumer Advocates
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