Any time a debt is forgiven, you run the risk of having to pay tax on the amount that is forgiven. The bank or card company may not warn you about this. Too often, I have had clients who received this surprise in the mail and they don't know what it is. Often it is sent with all the papers they receive documenting the debt forgiveness, and they file it away with that paperwork. A few years later they get a notice from the IRS.
1099C Cancellation of Debt is the form this surprise takes. If it’s from a credit card company, the amount of debt cancelled is usually the card balance the taxpayer owed. If it is because of a home foreclosure or a repossession of a vehicle or piece of equipment, the debt may be reduced by the amount the asset was later sold for. The bottom line is that if a lender forgives you a debt you can be taxed on the amount of the debt. Why? Because it could be a deductible expense for them. If they deduct it, someone has to be taxed for it. That’s you. The 1099-C is issued in the year that the credit card company or bank forgives the debt (when it comes off their books.) In the case of a repo or foreclosure, it may take a year or more for the process to be completed. At that time, you should receive a 1099C but as I mentioned earlier it could come with all the documents to close the debt. You many need to look for it. Since the lender has issued a 1099C, this income will show on the IRS matching program. If you miss it in the year it is issued, it will catch up with you later with penalties and interest.
Is there a way out of being taxed on the income from the debt cancellation? Yes, if you are insolvent at the time of the cancellation of debt. That means that all your debts are greater than all your assets. So let’s say you owe $20,000 in credit card debt and $30,000 on your house. If right before the credit card company cancels the debt, the Fair Market Value (FMV) of your house is $55,000, you have more assets than debt and you are not insolvent. Assets will include bank accounts, the FMV of homes, real estate, vehicles, and IRAs, cash value if life insurance policies and don’t forget the FMV of personal items like furniture, jewelry, and art work. Debts will include all your debts so don’t forget bills and taxes due. If you can’t claim insolvency, then the 1099-C will have to be reported on your 1040 and taxes paid.
If a lender, be it credit card company, bank, credit union, etc., forgives a debt you owe them, you have to understand that there may be tax consequences and prepare for it. For your specific situation, talk to your tax professional.