Cancellation of Debt Income

BILL'S ANSWER

Under federal law, a financial entity is required to send a taxpayer a "Form 1099C Cancellation of Debt" whenever it forgives or cancels a loan balance greater than $600. This may create a tax liability for you because the canceled debt is considered "income" for tax purposes. The amount of debt forgiven must be reported on Form 982 and this form must be attached to the taxpayer's tax return.

The financial entity, which may be a federal government agency, a financial institution (such as a bank), a credit union, or "any organization in which a significant part of its trade or business involves the lending of money" may issue a Form 1099C because Freedom Debt Relief negotiated a savings of more than $600 on a debt you had with a creditor.

You may have the ability to reduce or eliminate this so-called Cancellation of Debt Income (CODI) if you were insolvent immediately before the cancellation. For the purposes of completing Form 982, the IRS considers a taxpayer insolvent if the total of all of the person’s liabilities exceeded the fair-market value (FMV) of all of that person’s assets. To determine insolvency, assets include the value of everything the taxpayer owns (including assets that serve as collateral for debt and exempt assets which are beyond the reach of creditors under the law, such as interest in a pension plan and the value of a retirement account). Liabilities include:

• The entire amount of recourse debts, and
• The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt.

Here are two hypothetical examples the IRS uses to describe the cancellation of debt income concept:

Greg was released from his obligation to pay his personal credit card debt in the amount of $5,000. Greg received a Form 1099C from his credit card lender showing canceled debt of $5,000. Greg’s total liabilities immediately before the cancellation were $15,000 and the FMV of his total assets immediately before the cancellation was $7,000. This means that immediately before the cancellation, Greg was insolvent to the extent of $8,000 ($15,000 total liabilities minus $7,000 FMV of his total assets). Because the amount by which Greg was insolvent immediately before the cancellation exceeds the amount of his debt canceled, Greg can exclude the entire $5,000 canceled debt from income.

Assuming the same facts as above, let us say that Greg’s total liabilities immediately before the cancellation were $10,000 and the FMV of his total assets immediately before the cancellation were $7,000. In this example, Greg is insolvent to the extent of $3,000 ($10,000 total liabilities minus $7,000 FMV of his total assets) immediately before the cancellation. Because the amount of the canceled debt exceeds the amount by which Greg was insolvent immediately before the cancellation, Greg can exclude only $3,000 of the $5,000 canceled debt from income under the insolvency exclusion.

More Information on Cancellation of Debt Income

The Internal Revenue Service document Publication 4681 contains more information on the tax consequences of canceled debt. It also contains specific instructions on how to complete Form 982.

If you receive a 1099C keep it with your other tax documents. Be certain to give the 1099C to your tax preparer, and give the tax preparer information regarding your total liabilities and the FMV of your assets as they were immediately before the cancellation.

Mortgage Forgiveness Debt Relief Act

I realize your cancellation of debt income question is not related to a mortgage, but I am mentioning the Mortgage Forgiveness Debt Relief Act in case you have heard about a federal program that forgives debts and are curious about it. The Mortgage Forgiveness Debt Relief Act provides tax relief for mortgage loans on primary residences forgiven in 2007 through 2012. See the IRS document "The Mortgage Forgiveness Debt Relief Act and Debt Cancellation" for more information. Again, this program does not help you with your debts settled with a debt negotiation, consolidation, or resolution program.

If your debts are causing you financial distress, access the Bills.com debt saving center to get no-cost quotes from pre-screened service providers.

I hope this information helps you Find. Learn & Save.

Best,

Bill

Bills.com

Comments (58)

West W.
Beverly Hills, CA  |  February 03, 2012

Hello. My spouse purchased a vehicle, prior to knowing each other. At some point thereafter, my spouse stopped making payments and immediately called the lein holder stating the financial inability to make futher payments. The lein holder made mutual arrangements to repo the vehicle which commenced shortly thereafter. This all occurred back in 2005 - again; prior to us knowing each other whatsoever. Fast-forward to present Jan 2012. My spouse receives a 1099-C "Cancellation Of Debt" letter from the prior lein holder. It states that, in 2011, the lein was cancelled (unbeknownst to my spouse ~ first notice of this fact) and that the outstanding amount would be considered income and, as such, was reported to the IRS. My question is rather simple: Since spouse is not employed, nor has been for many years due to raising a family, what obligation if any does my spouse have to this situation? Moreover, am I responsible in any way to pay income tax on a transaction (purchase and subsequent repo) that transpired well before we ever met?! It would seem to me that, when one meets a potential spouse, you no longer should only ask how many people they've slept with; you should also request full details of their past unsettled finances.

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Bills.com
February 04, 2012

First, your spouse will almost certainly need to file a tax return for the tax year indicated on the 1099.

Second, whether a person has liability for a spouse's pre-marital debt depends on your state's laws. You indicated you reside in California. See the Bills.com resource California Loan Defaults and its comments for a discussion of this issue.

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West W.
Beverly Hills, CA  |  February 05, 2012

Bill, Thanks. The spouse's transaction occurred in Florida. We've since relocated. Do you have any insight into that state? Also, I spoke with a tax professional who suggested that insolvency rules may benefit my situation. I don't have a clear understanding of how that works; would you kindly share your insight? Thank you!

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Bills.com
February 06, 2012

See the Bills.com resource Florida Collection Laws to learn about the rules in that state.

The best resource Bills.com offers on CODI is found on this page. Follow our links to IRS resources learn more about Cancellation of Debt Income, and which forms to use. Alternatively, consult with a lawyer who has tax experience.

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Mary S.
Lincolnton, NC  |  January 25, 2012

After doing my taxes last year and sending them off I received a 2010 1099 for cancellation of debt. But the debt wasn't canceled until 1/11/11. So I contacted H&R block and they said I claim it for the year it was canceled. So I was going to claim it this year for 2011 taxes. Well all around December I get a letter from IRS saying I need to pay the taxes on that debt ($2300). I sent back a signed statement on to why I didn't claim it last year that It wasn't canceled off until 2011 so I feel that I need to claim it for 2011 income then. Plus I was never contacted from this place to begin with for payment until I looked into buying a house thats when they sent the 1099. Now IRS says that its a 2010 1099 so I was supposed to claim it then. I just don't see how I can claim income for 2011 in 2010. Please help.

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Bills.com
January 25, 2012

The document you receive on 1/11/11, should have been a 1099 for the 2010 tax year. I recommend that you review the document again. Show it to the H&R Block people who gave you the original advice. However, it may just be prudent to pay the taxes on the debt. In any case, you will have to declare the income and pay taxes on it in one year or another.

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Mary S.
Lincolnton, NC  |  January 26, 2012

But the date of cancellation was 1/11/11 so that should be income for 2011 not 2010.

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Bills.com
January 26, 2012

Since you stated that the document is a 2010 1099, I assumed that this was a 2010 tax issue and that is why the IRS claimed that it was income for 2010. I recommend that you speak with a tax professional. Bring the document and also ask about IRS form 982, which could be a way for you to avoid having to pay taxes on the amount listed on the 1099-C as income.

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Richard L.
Santa Clarita, CA  |  January 16, 2012

Hi, I received a letter from the IRS that I owe $1,200 because I didn't report 1099 forgiven debt. I am trying to figure out if I am insolvent. I have a home worth $420,000 FMV and I owe on it $410,000 I owe $60,000 in credit cards. I own 3 cars total worth is $10,000 When i reply to the IRS do I send proof of all this? It doesn't give space on the 982 for itemization. Thanks and I love your site. Richard

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Bills.com
January 17, 2012

You can use the IRS link, as provided above on the page to access a worksheet to help you prepare the 982 form.

I also recommend that you consult with a professional tax preparer to fill out the form and your tax returns, whenever a Form 982 is involved. If you can't prove that the IRS is wrong about its $1,200 assessment, I am afraid that you will have to pay them in full or set up a long-term payment plan.

I am glad you enjoy and keep coming back to the Bills.com Web site.

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Mark R.
Beaumont, TX  |  December 08, 2011

I was just granted a conditional student loan discharge. It will be discharged after the 3 year monitoring period. My student loans were over six figures. Will they send me a 1099c in the year the loans are discharged? They were with the Dept of Ed, now Nelnet is servicing them. And on the insolvency test for 1099c, can I use the amount of potential tax liability to show that I am insolvent.

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Bills.com
December 08, 2011

I recommend speaking with a tax professional, as only a tax professional can properly give tax advice. Also, because your potential tax liability would be large, it is even more important that you consult with a tax professional. You should discuss the IRS Form 982 and whether you should file that for the year that the debt is forgiven, even if you don't receive a 1099-C.

You should also speak about IRS Publication 4681 and whether you meet the test for insolvency.

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Worried K.
Charlotte, NC  |  June 19, 2011

My relative is undergoing the foreclosure process and asked me for knowledge about this new law in his situation. He has refinanced about 8 times in the last 10 years and a couple times it was to reduce his payment because the rate went down, a couple to improve the house, and a couple to refinance debt. He paid down on the house 20% when he purchased it. Right now he owes what the tax value is, but we are almost certain it will sell for WAY less. It is in bad shape and falling apart. Which debt will be non taxable according to this new law? Will they just work based on the last refinance and compare the two? Thank mucho! We are so worried

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Bills.com
June 20, 2011

The balance of the present loan, and the market value of the property are the two key numbers to focus on.

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Worried K.
Charlotte, NC  |  June 20, 2011

Well im writing again in response to your answer. The tax value is around what is owed according to the loan, but we been told by relators that we should expect to get 40000-50000 below the amount listed on the tax value (aka fair market value, which is not equal to the property tax value). Unfortunately, it was a victim of hail storm and other problems which we could not afford to fix with the high deductible. Under the mortgage cancelled debt ACT which amounts will they assess? or what approximately should we expect to owe in taxes? Thank you!

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Bills.com
June 20, 2011

The market value matters. Get an estimated market value by looking at the recent sales prices of of comparable, nearby properties. A place to start online is Zillow.com.

The tax value is significant only for the purposes of paying taxes, and nothing more. Unless you have a property tax issue, ignore the value the county tax assessor places on a property.

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Worried K.
Charlotte, NC  |  June 20, 2011

Sorry if im asking you so many questions. I went on zillow and it said the current value is 130,000 and the loan amount is 175,000 right now. The original purchase price was about 120,000 almost ten years ago. We put about 10,000-20,000 into fixing it up in major repairs since then also. There is a foreclosed house about half a mile away selling for 85,000. Am I correct in thinking then: if the bank can sell the house for 60000. That leaves about 115,000 cancelled debt. And under this ACT, since about that much was spent purchasing and fixing it up despite multiple refinances- hypothetically it could be forgiven under this law? Thank you!

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Bills.com
June 21, 2011

I do not seem to be interpreting the Mortgage Forgiveness Debt Relief Act or how the IRS calculates the cancellation of debt income the way you are. Let us use a hypothetical example to illustrate how I understand both.

• Mortgage Forgiveness Debt Relief Act: Homeowner has a $100,000 mortgage or deed of trust balance. He or she short-sells the property for $75,000, and the lender issues a 1099-C indicating the $25,000 deficiency balance is canceled and it will not pursue the borrower for the deficiency. Under the Mortgage Forgiveness Debt Relief Act, the $25,000 deficiency is not considered income because the property was the homeowner's residence.
• Cancellation of Debt Income (CODI): Same facts; short sale resulting in a deficiency balance. If the homeowner/borrower is insolvent when the debt is forgiven or canceled, the forgiven debt is not income. This is a bit tricky, so review the analysis in the main answer above.

No where in the IRS discussion of CODI or the Mortgage Forgiveness Debt Relief Act is, according to my reading and understanding, the inclusion of the homeowner's basis in the property (original purchase price), or improvements, or prior refinances of the mortgage in question. Your discussion of money spent on home improvements and repairs is not germane to either CODI or the Mortgage Forgiveness Debt Relief Act. If I overlooked allowances for repairs or improvements in my reading of either, I welcome your correcting my oversight.

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Brian B.
Phoenix, AZ  |  June 04, 2011

When calculating assets and liabilities in order to determine insolvency., I understand that 401ks must be counted but I'm wondering if the penalty can fee can be subtracted since in order to liquidate those, one would need to pay a penalty of 10%. For example, if you had a $50,000 401k and you withdrew it, you would on;y have $45,000. Would $45,000 be considered the FMV? Same for selling a home, can you deduct the presumed realtor fees and closing costs?

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Bills.com
June 06, 2011

You ask an excellent question. I can tell you that when it comes to determining a fair market value for a retirement account for qualifying for an Offer in Compromise, the IRS sets the value of the account at what you would have after the penalties and taxes are paid.

Common sense would dictate that the IRS would use the same formula when reviewing an IRS Form 982 that is used for cancellation of debt. However, when it comes to common sense and the IRS, the two do not necessarily have to meet. I suggest that you address your question about both retirement accounts and real estate values to an experienced tax professional, in order to get an authoritative answer and best insulate yourself from unexpected tax liabilities. Please report back, if you get an answer that can be shared with other readers.

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Carla C.
Round Lake, IL  |  May 19, 2011

I received notice from IRS that i owe $972+ from an old car repo (that was 1999) due to the COD of $6500+. it claims the IRS received notice for the 2009 tax year from the loan company. i never received any notice. what do i do?

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Bills.com
May 21, 2011

I have two suggestions:

1. Review the IRS Form 4582. It is used to challenge a bogus 1099.
2. Call the Office of the Taxpayer Advocate at 1-877-777-4778. The Advocate's job, according to the IRS Web site is "to ensure that every taxpayer is treated fairly, and that you know and understand your rights." Explain the facts of your case to the Advocate; that the 1099 is related to a car that was repo'd in 1999 and that the 1099 was not issued until 2009.

Please report back on what you find out.

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Barry K.
Shoreview, MN  |  April 17, 2011

End of Jan 2011 I received a 1099C - second mortgage cancellation from the financial institution. There was prior discussion relating to the debt cancellation. I tried to contact the financial institution several times to find out the reason for the cancellation, but there was no response. Also in December the collection calls stopped. I complete my tax return with the 1099C document. In the second week of April (last week) I receive a letter from the financial institution that they issued/mailed the 1099C in error and they have not filed the form with the IRS. The notice should be disregarded. So my question is where do I stand legally and are they trying to reinstate the debt if that is the case.

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Bills.com
April 18, 2011

Consult with a tax attorney who can:

1. Determine the tax implication the reversed 1099-C has for you
2. Research if you have a cause of action (a legal reason to file a lawsuit) against the vacillating lender.

Mortgage servicers, as a group, are in such disarray that it is impossible to predict their behavior.

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