If a credit card company or other creditor cancels your debt, that’s really good news, right?
Such cancellation of debt usually happens when the creditor gives up on collecting the debt, or when the statute of limitations on collecting the debt runs out.
Cancellation of debt is not all positive news, however.
You should receive a Form 1099-C, Cancellation of Debt from the company, which they also send to the IRS. The amount of debt shown on Form 1099-C as cancelled is taxable income on your return, unless you qualify for an exception.
When banks are required to report cancelled debt
If your debt is cancelled by a bank, the bank must report it to the IRS. The IRS requires banks to report cancellation of debt due to one of nine “identifiable events.” The most common of these events are:
- A debt discharged in bankruptcy
- Other federal or state court proceedings that make a debt unenforceable
- Expiration of the statute of limitations for collecting a debt
- A negotiated settlement with the debtor
- Discontinuation of collection activity, whether it is based on a decision or as part of their defined policy
It may not be clear to you as the debtor why the bank or creditor decides to report to the IRS.
Nevertheless, if you receive Form 1099-C, you must pay tax on the cancelled amount unless you meet an exception to the rule.
Exceptions to the rule
1. The main exception to paying tax on cancelled debt is if you can show that you were insolvent when the debt was cancelled.
To be insolvent means that you had more debts than assets. If you couldn’t pay your bills and the bank cancelled your debt, you probably qualify.
You must have been insolvent immediately before the debt was cancelled. It’s not enough to tell the IRS you were insolvent. You must fill out an IRS insolvency worksheet to prove your debts were greater than your assets.
If you weren’t insolvent, you generally must pay tax on the cancelled debt.
2. If these debts were discharged because you filed for bankruptcy, you were insolvent. You do not have to pay tax on the cancellation of debt.
How much tax do you have to pay?
Paying the tax is still better than paying the entire balance.
For example, if you’re in the 15 percent tax bracket, an additional $1,000 in taxable income will cost you around $150.
The IRS will tack on interest expense, but fortunately the interest rates for individuals are relatively low.
Have you ever been surprised to receive a notice of cancellation of debt from a long-forgotten debt or a debt you didn’t know you owed?
Photo credit: chrisschoenbohm