How Will a 1099-C Affect Our Income Taxes?

Keep records in case you have to contest a Form 1099-C.

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When a creditor decides not to pursue – or can’t pursue -- you on a debt, it will send you a Form 1099-C. By doing so, the creditor triggers various tax consequences. The creditor writes off the uncollectible debt to avoid paying taxes on money it will never see. The cancelled debt may free you from a creditor, but can also increase your federal income tax bill.

Defining Cancellation of Debt

Creditors cancel debt by completely forgiving it, accepting less than what you owe or reducing your loan balance for an early payoff or loan modification. Compromises on disputed debt to avoid lawsuits and modifications that only lower interest rates are not cancelled debt. Cancellation also occurs when other events result in a discharge of debt, such as a bankruptcy, a judicial foreclosure, or a ruling that the creditor waited too long to sue. A foreclosure doesn’t lead to cancellation of debt in certain circumstances. For example, if you live in a so-called non-recourse state, you are not personally responsible for any remaining balance on your mortgage debt, and therefore, there's nothing for the lender to cancel.

Taxing Cancelled Debt

Generally, you owe taxes on cancelled debt, because the IRS considers it income -- it's money that the creditor now says you do not have to repay. At the time you borrow, of course, it's not considered taxable income because you are obligated to pay it back. When your debt is absolved or discharged, however, you "keep" money that you no longer have to pay back. This windfall is treated as income.

Exceptions to Taxation

You do not pay taxes on debt cancelled by a bankruptcy discharge or when you were insolvent, meaning your total liabilities exceeded the value of what you owned. Debt cancelled because of a foreclosure on your main home is excluded if you took out the mortgage between January 1, 2007, and December 31, 2013. However, you must use the cancelled debt when calculating the cost -- and therefore the tax basis -- of your home. For example, if $50,000 of debt was cancelled, that reduced your cost to buy the home by $50,000, which boosts any capital gains you realized on the home sale by $50,000 as well.

Responding to Form 1099-C

You need to contact the creditor if you disagree with any information reported on Form 1099-C, such as the fair market value. If the creditor does not send you a corrected Form 1099-C and you still disagree with the information, you need to send a letter and supporting papers along with your tax return when you file it, explaining why the creditor is wrong; this can include your billing statements or a value from a reputable source. You can use Form 982 to report cancellation of debt income you want to exclude if you were insolvent; you provide a list of your assets and liabilities.