How to Reduce or Eliminate the Impact of a 1099-C as a Result of a Settled Debt

Debt negotiation can bring much needed relief to your monthly budget and to your emotional well-being. No longer are you kept up at night wondering how you will pay the bills, catch up on late payments, or deal with collection calls.

Yet, according to IRS rules, when a debt is negotiated and settled for less than the full amount, you might end up with a surprise at the end of the year in the form of a 1099-C or 1099-A. This means you may be required to include the discharged amount on your income tax return and that amount will be counted as income.

When Could You Receive a 1099-C (or 1099-A)?

The 1099-C is issued by the lender when a debt is forgiven or discharged and you are no longer responsible for repaying the debt. This can occur through a bankruptcy, a home foreclosure that does not sell for enough to pay off the mortgage, some student loan discharges, and some debt negotiation settlements of credit card debt.

The lender sends the 1099-C to you along with one to the IRS. This means if you get a 1099-C, you must address it or it could flag an audit by the IRS. Adding a large amount to your income could result in a smaller refund or you owing the IRS when April 15th rolls around.

What Are the Exceptions?

The good news is that there are three key exceptions to the tax that will enable you to reduce or eliminate any tax obligation due to the 1099-C. These can be found on form 982.  (,-Reduction-of-Tax-Attributes-Due-to-Discharge-of-Indebtedness-(and-Section-1082-Basis-Adjustment)

1) Debt cancellation on your primary residence. If you lost your home to foreclosure and the house sold for less than you owed the bank, you might receive a 1099-C for the amount of debt that was discharged. If the foreclosure occurred between the years of 2006 and 2010, you were able to use the principle residence exception to reduce or eliminate this debt discharge, if the mortgage balance was used for the purchase or improvement of the home.

2) Bankruptcy through Title 11 also offers the ability to reduce the full amount of the 1099-C from tax liability. As long as the debt was discharged in the bankruptcy and is listed on the court approved paperwork, then you can file the 982 under the bankruptcy exception.

3) Insolvency at the time of the discharge. This last exception is perhaps the most often used exception by consumers who are enrolled in a debt negotiation or credit card modification program. If you were insolvent at the time the debt was forgiven, you are able to claim this exception to reduce or eliminate tax liability for the discharged debt. Insolvency is defined as having more debt than you own in assets. The reduction in the discharge amount is to the extent of your insolvency.

For example, if you owe $50,000 on credit cards, $40,000 in student loans, $25,000 for a vehicle and $250,000 for your home, then you have $365,000 in total debt. Let’s say your vehicle is valued at $27,000 and your home is worth $300,000. Your total assets total $327,000. In this example, you could have $38,000 in discarded debt that you would not owe taxes for. If you paid $20,000 in debt through debt negotiation, then the $30,000 in forgiven debt would not be taxable. A tax advisor can assist in determining if you qualify.

For many consumers struggling with high debt, the insolvency exception may help reduce or eliminate the debt listed on a 1099-C. Also, not all creditors report debt settlement discharges and only reported debt forgiveness must be claimed.

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