“Forgiveness of Debt” Income: How To Avoid Tax Surprises

When someone files bankruptcy, they receive their discharge and most often, they believe that to be the end of it, aside from having to rebuild their credit rating. However, they can receive a nasty surprise at tax time, in the form of a 1099-C.

Why Call It Income?

Many take issue with the fact that this is classed as income at all – they may see it as being lucky, almost as a gift, that their debt was not enforced. The Internal Revenue Service (IRS), however, sees it differently. The IRS rationalizes that a debtor whose debt is cancelled is actually coming out ahead of where they were, because more often than not, whatever basis on which they incurred the debt is not cancelled or taken – for example, if you own a restaurant, and you default on a debt to a cattle rancher, the rancher does not come take all the beef in the restaurant. If the recovered income were not taxed, the debtor would have both the money and the items or services they paid for. That would qualify as a windfall, or windfall profit – an unforeseen profit above what is needed to make someone whole – and generally, windfalls are frowned upon.

Despite this rationale, there are certain cancelled debts that are excepted or entirely excluded from gross income. Most of them are excluded because to include them would adversely affect business interests or handicap young people starting out. Some of them are:

  • Certain qualified student loans;
  • Income disqualified by law, such as gifts, bequests and similar categories regulated by other areas of law;
  • Any debt cancelled within the framework of a Chapter 11 bankruptcy;
  • Debt cancelled during insolvency; and
  • Qualified farm, principal residence, or real property business indebtedness.

Procedure

Any bank or financial institution that writes off more than $600 of a debt’s principal (that is, not fees or interest accrued) must send you a Form 1099-C with which you can report the income on your tax return. It is imperative that you keep any 1099-C you receive; many people who receive them throw them away, under a mistaken belief that since they are from the bank or debt collector they negotiated with, that the form is no longer applicable.

It is also important to understand when you should by rights receive a 1099-C, even if you do not. It is not uncommon for a creditor to send the form to the IRS, but not to you, and it may wind up posing a significant problem if your tax return does not match up in terms of what is owed. You are expected to report all gross income, even if you do not receive the appropriate form.

In short, in the same year that you settle a debt for less than its full value, you should expect a 1099-C from your creditor or financial institution. Even if you do not receive one, however, you must report the cancelled debt as gross income, or you risk an audit.

Get Professional Help

It can be frightening to get a notice saying you owe money that you thought you could recoup. If you need assistance, our attorneys can help. We have years of experience and success in the tax field, and we are happy to put that knowledge to work for you. Contact our New York City office for a free consultation today.

 

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