If a creditor writes off a debt you owed, or if you settle a debt for less than the full amount owed, you may owe taxes on the "income" (that is, the amount written off). If that's the case, you'll get a 1099-C from the financial institution that forgave the debt. Luckily, there are some exceptions to the rule that you must pay taxes on the amount written off.
Read on to learn why you might owe taxes, when you'll get a 1099-C, and what exceptions apply.
Why Do You Owe Taxes on Charged Off or Settled Debt?
Sometimes a lender believes a debt is uncollectible (for example, if the debtor is unemployed). In that case, it might write off the debt in its books and claim it as a business loss for tax purposes. Other times, you may negotiate a settlement with the lender for less than the full amount owed.
In both of these case, the IRS counts the forgiven debt as "income." Its view is that you now get to keep that money, and so you have been enriched by the forgiven debt. And of course, the IRS expects you to pay taxes on this income.
When You Must Pay Taxes on Forgiven Debt
If a financial institution has forgiven $600 or more of the principal balance of a debt (interest and fees are not included in this amount), it must send you a Form 1099-C to you. You must then report this amount as income to the IRS.
Exceptions to the Reporting Rule
If you get a 1099-C, you don't have to report the amount as income if one of the following applies:
- the debt was a nonbusiness debt and was canceled before 2007 as a result of Hurricane Katrina
- a student loan was canceled because you worked in a profession and for an employer as promised when you took out the loan
- if you had paid the debt, it would have been deductible anyway
- the lender wrote off the debt as a gift to you (this doesn't happen very often)
- you discharged the debt in Chapter 11 bankruptcy, or
- you were insolvent before the creditor agreed to settle or write off the debt. (You are deemed "insolvent" if your debts exceed the value of your assets.)
Additional Exceptions for Cancelled Mortgage Debt
You must also report "income" from debt written off after a foreclosure or property repossession. However, the Mortgage Forgiveness Debt Relief Act of 2007 provides some exceptions for mortgage debt forgiven from 2007 through 2012.
In order to qualify for the exception, the forgiven loan must have been on your primary residence, the loan must have been used to buy or improve that house, and usually you can exclude up to $2 million of the forgiven debt (meaning you don't pay taxes on that amount).
Loans on real estate other than your primary residence, or taken out for things other than to buy or improve your home (for example, home loans taken out to pay college tuition) do not qualify for the tax exclusion.
To learn more about the Mortgage Forgiveness Debt Relief Act, see Nolo's article Canceled Mortgage Debt: What Happens at Tax Time?