Settling debt for less than what is owed on the debt can create tax liability. This article discusses this issue, and how bankruptcy and even insolvency may resolve this issue.
By settling debt for a fraction of what you owe may open the door to tax liability. For example, you settle a debt for $5,000 that has a face value of $12,000. By settling this debt, for $5,000, the creditor will cancel the remaining $7,000 owed. This cancelled debt then becomes taxable income to you and a 1099c is issued for $7,000. This $7,000 is added to your tax base for the tax year the debt was cancelled, and you must pay taxes on this $7,000. Many times, the cancelled debt is much larger than $7,000, and in some instances, may reach into the tens of thousands of dollars. As long as the cancelled debt is over $600, the creditor may send you a 1099c (and send a copy to the IRS as well), and this will become taxable income.
Bankruptcy, however, solves this issue, provided you file a bankruptcy prior to the cancellation of the debt. If you file bankruptcy, the debt will be discharged, not cancelled. The creditor will not be allowed to cancel the debt at this point, as it was included in the bankruptcy filing.
What if the debt is cancelled and a 1099c issued before you have an opportunity to file bankruptcy? Or, how can you deal with future cancelled debt if you choose not to file bankruptcy? Insolvency. If you can show that you were insolvent on the day that the debt was cancelled, causing the 1099c to be issued, then this cancelled debt income is waivable. Insolvency basically means that your liabilities exceed your assets. And to show that you are insolvent, IRS Form 982 must be completed and submitted with your Federal tax return. Upon receipt of IRS Form 982, the IRS will determine if you were insolvent and if the cancelled debt income thereby is waivable. Often, I will have clients who have cancelled debt income meet with a CPA to prepare the tax return and IRS Form 982.
If you are facing cancelled debt income (1099c income) or are interested in bankruptcy, please contact me today to schedule your free in-office bankruptcy consultation in Eugene.