How to Eliminate the Taxes Owed on Forgiven Debts

A personal financial crisis often occurs when you lose employment, have large unexpected bills, or other monetary calamity that you are unprepared to face. During this time, keeping up with essential bills may be all you can manage. Debt relief, delivered through a qualified debt settlement agency or consumer law firm, allows you to eliminate bills on unsecured debts by paying less than the full balance owed.  The debt in turn is reported as “Settled in Full” and no further obligation is required for repayment of the original balance.

While the settlement debt can provide much needed financial relief, in a very small number of cases you could also face taxation of forgiven amounts at a time when you are still struggling financially. However, there are several ways you can reduce or eliminate entirely this tax obligation.  Here is what you need to know if you receive a 1099-C tax form based on canceled debt.

What is a 1099-C?

A 1099-C notifies the IRS of the Cancellation of Debt Income (CODI). When you receive a 1099-C, you must report the income on your tax return. The IRS taxes debt forgiveness as ordinary income.

When Could You Receive a 1099-C?

Creditors who forgive more than $600 in debt, while not obligated to do so,  could issue a 1099-C.

Do You Qualify for an Exclusion or Exemption?

Before paying taxes on a 1099-C, review the exclusions and exemptions that might reduce or eliminate IRS taxation.

IRS Exclusions to debt cancellation include the following:

• Debt canceled due to a bankruptcy
• Debt canceled due to insolvency
• Cancellation of a qualified farm indebtedness
• Qualified property indebtedness
• Debt forgiveness due to home foreclosure or short sale before January 1, 2021

IRS Exceptions to debt cancellation include the following:

• Canceled debt as part of a gift, bequest, or inheritance
• Some qualified student loan debt cancellation met by working for a certain period of time
• Education loan repayment programs for health service workers employed in certain areas
• Qualified property price reduction offered by a seller to the buyer of real estate
• Reduction in the principal balance of a home due to Pay for Performance Success Payments through a qualified modification
• Student loans that are discharged because of the death or disability of the student

If you qualify for an exclusion or exemption, you must complete IRS form 982 to justify your claim.

Proving Insolvency

One of the most common ways to lower or eliminate taxation on a forgiven debt is to prove insolvency. To meet the IRS criteria, add up your total assets and compare that with total debts. If your liabilities (debts) exceed your assets, you can claim insolvency.

Any debts forgiven within the insolvency gap are not taxable.

For example, if you owe $50,000 in debt (before debt forgiveness) and own $40,000 in assets, you are deemed insolvent with a $10,000 gap. In this case, you can exclude up to $10,000 in forgiven debt due to your insolvency. However, the IRS will tax any forgiven amounts above the $10,000.

Form 982 provides the necessary paperwork to claim an exception or exemption, including insolvency. If you have previously paid taxes on forgiven debt in error, you can modify your tax return for up to three years to correct the mistake.

Final Thoughts

Most consumers that settle debt do so because they do not have enough assets and income to cover the debt payments. When this is the case, it could be possible to reduce or eliminate the taxes owed and effectively invalidate any 1099-C’s filed for the forgiveness of debt as the result of a negotiated settlement.