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Why you owe taxes on income you never saw

If you had debt canceled last year, perhaps through a foreclosure or short sale, you probably received a 1099-C listing the canceled debt as income. Here's how to cope.

By MSN Money Partner Feb 11, 2013 2:33PM

This post is by Gerri Detweiler of


1099-C questions answered, or why you have to pay taxes on cancelled debt. © Corbis"What is a 1099-C?" That’s the question millions of taxpayers will be asking as these forms land in their mailboxes. An estimated 5.5 million 1099-C forms will be filed for the 2012 tax year.


If you received one of these forms, your first reaction may have been panic. "Why did I get this?! What does it mean?!" Then you probably starting searching online to learn more — and that’s what brought you here. So let’s get started.


What is a 1099-C?


A 1099-C reports Cancellation of Debt Income (CODI). A lender is supposed to file a 1099-C form if it "cancels" $600 or more in debt. It files a copy with the IRS and is required to send a copy to the taxpayer as well.


Four common reasons for a 1099-C are:

  • You negotiated a settlement to pay a debt for less than the amount you owed and the creditor forgave the rest.
  • You owned a home that went into foreclosure and there was a deficiency (a difference between the home’s value and what you owed on it) which was either forgiven or remains unpaid.
  • You sold a home in a short sale where the lender agreed to accept less than the full balance due.
  • You did not pay anything on a debt for at least three years and there has been no significant collection activity for the past 12 months.

If you’re not sure why you got one of these forms, you should see a code in Box 6 that describes the "identifiable event" that triggered the lender to send this form. You can match that code up with the reasons listed on page 3 of Publication 4681.

Does this form mean I don’t owe that debt anymore?


Not necessarily. If you receive a 1099-C because you paid off the debt for less than the full amount due in a negotiated settlement, then clearly you don’t owe any more money.


However, if the form was filed because you haven’t made payments for three years and they haven’t tried to collect recently, then you may still owe the debt. Your state’s statute of limitations may be more relevant in this situation.


If I get a 1099-C do I have to pay taxes on that amount?


Maybe. The IRS will automatically assume that the amount listed on the 1099-C is accurate and expect you to include that amount in your ordinary income when you file your tax return. Depending on the other income you earn and your tax bracket, the result could be a larger tax bill or smaller refund.


However, if you can demonstrate that you qualify for an exclusion or exception, you may be able to avoid paying taxes on part or all of that phantom income. One of the most commonly used exclusions is the "insolvency exclusion." It works like this: You are insolvent to the extent that your liabilities (what you owe) exceed your assets (what you own). If the total amount by which you are insolvent is larger than the amount listed on the 1099-C, you can exclude the entire amount listed on the 1099-C from your income. You’ll have to file Form 982 with your tax return to claim this exclusion. If the amount by which you are insolvent is less than the amount on the 1099-C then you may be able to avoid including part of that amount in your income.


Another popular exclusion is the Mortgage Forgiveness Debt Relief Act of 2007, which allows taxpayers to avoid paying taxes on up to $2 million of debt forgiven on their principal residence ($1 million if married filing separately). This exclusion applies only to debt used to purchase or improve the property and only if the discharge is directly related to a decline in the home’s value or the taxpayer’s financial condition. In other words, if you took out a home equity loan to pay off credit card debt and never paid it back, you aren’t going to qualify for this exclusion on that part of your debt (though you may qualify for the insolvency exclusion).


The one thing you should not do is ignore these forms. If you leave this income off your tax return completely, you will likely get a notice from the IRS. Depending on your situation, the IRS may inform you that you owe money because you failed to include that amount in your income.


Why does the IRS expect me to pay taxes on debt I couldn’t pay in the first place?


Good question. The theory is that you received "income" that you didn’t pay taxes on, even if that income didn’t come in the form of a paycheck. That explanation is easier to swallow in some cases than in others. For example, if you used your credit card and paid for a $5,000 cruise but then never paid the credit card company, it does seem reasonable that the $5,000 your card issuer "gave" you should be considered taxable income. If this provision didn’t exist, then lending money to someone and forgiving the balance would be an easy to way to avoid taxes.


On the other hand, it’s harder to understand why these rules in situations where a big portion of the debt that was "canceled" was due to exorbitant interest and fees charged by a lender. Or what about when student loan borrowers become totally and permanently disabled and get federal student loans canceled as a result? They may get a 1099-C listing tens of thousands of dollars in CODI at a time when they can least afford it.


What happens if I don’t get a 1099-C for a debt I settled or for a debt I never paid?


The IRS expects you to pay taxes on cancelled debt regardless of whether this form was filed. Publication 4681 says: "Even if you did not receive a Form 1099­C, you must report canceled debt as gross income on your tax return unless one of the exceptions or exclusions described later applies."


Most tax advisors we have spoken with suggest taxpayers with a clearly identifiable event — a short sale of a home or a negotiated settlement with a credit card company, for example — go ahead and include the canceled debt in their taxable income for the year in which it happened along with Form 982 (if it applies) and an explanation to the IRS. If the lender tries to send a 1099-C in the future they can then explain they already reported that COD income.


Besides following the rules, there is another advantage to this approach. The insolvency exclusion is supposed to be calculated at the time the debt was canceled. It’s much easier to figure out the insolvency worksheet for the current year — and much harder if you try to reconstruct your financial situation several years down the road.


What do I do if I don’t agree with the amount listed on a 1099-C?


There is no clear or specific procedure for disputing a 1099-C. The IRS does not offer a form that can be used for this situation. Most tax professionals suggest that you try to straighten it out first with the creditor who issued the form. Creditors are supposed to provide a dedicated phone number on the form for recipients who have questions about the form they received.


If you can’t resolve it with the creditor, then you can include an explanation with your tax return. Be forewarned, however, that this could trigger an audit of part or all of your return.


I got a 1099-C for a very old debt. Is that legal?


This is another tricky situation, and we have received numerous complaints from consumers who have received these forms for bills they had stopped paying on long ago. Creditors who follow IRS guidelines should send out 1099-Cs when debts lie dormant for three years and there has been no significant collection activity for the past year. Specifically, the IRS instructions for 1099-C state: "The expiration of non-payment testing period. This event occurs when the creditor has not received a payment on the debt during the testing period. The testing period is a 36-month period ending on December 31."


It goes on to say that the creditor can rebut this occurrence if "The creditor (or a third party collection agency on behalf of the creditor) has engaged in significant bona fide collection activity during the 12-month period ending on December 31."


The problem is that if a creditor sends out a 1099-C years (or decades), after it’s supposed to, the responsibility falls upon the taxpayer to try to explain to the IRS why he believes it should not have been filed that year. Again, there is no specific form for reporting this kind of dispute. You’ll have to include an explanation and you may wind up arguing with the IRS to get it resolved.


However, taxpayers can take heart in knowing that a couple of Tax Court cases involving this issue were resolved in the taxpayer’s favor.


I didn’t pay a debt. How do I find out if a 1099-C was filed?


Call the IRS at 800-829-1040 and request a wage and income transcript for the tax year(s) in question. It should list any 1099-C that was filed under your Social Security number.


I filed for bankruptcy. Do I have to pay taxes on debts included in my bankruptcy?


You don’t have to pay taxes on personal debts discharged in bankruptcy. And creditors aren’t required to file 1099-Cs for those debts. If they do, however, you can file Form 982 and claim an exclusion because the debt was included in bankruptcy.


Don’t panic if your bankruptcy occurred long ago and you don’t know where to find a copy of your bankruptcy papers to prove the debt was discharged. Although it’s anyone’s guess why a creditor would send a 1099-C that is not required years after the fact, you won’t likely have to jump through hoops to prove the debt was discharged. Filing Form 982 will usually suffice.


Do I have to pay taxes on interest and fees that were later written off?


The 1099-C may or may not include interest. IRS instructions state that including interest on the form is optional. The same is true of "nonprincipal amounts" such as penalties, fines, fees and administrative costs. It is up to the lender whether to include those. If they are included, you may or may not have to pay taxes on that amount. According to the IRS, "Whether the interest portion of the canceled debt must be included in your income depends on whether the interest would be deductible if you paid it."


I received a 1099-C for a debt my ex was supposed to pay. What now?


The IRS generally expects creditors to file 1099-Cs for joint debts. Whether or not you are required to pay taxes on that amount depends on who actually receives a Form 1099-C showing the full amount of debt. If you and another person were jointly and severally liable for a debt that is canceled, each of you may get a Form 1099-C showing the entire amount of the canceled debt. However, you may not have to report that entire amount as income.


The amount, if any, you must report depends on all the facts and circumstances, including:

  • State law.
  • The amount of debt proceeds each person received.
  • How much of any interest deduction from the debt was claimed by each person.
  • How much of the basis of any co-owned property bought with the debt proceeds was allocated to each co-owner.
  • Whether the canceled debt qualifies for any of the exceptions or exclusions we’ve described here.

Please understand that the information in this article is strictly for educational purposes. We strongly encourage you to get professional advice from an attorney or tax professional. Finally, if you are as frustrated by these forms as many of our readers, contact your elected officials in Washington and let them know the kinds of problems you are experiencing.


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Feb 11, 2013 7:03PM

If we aren't there yet, we appear to be quickly approaching the point that it is more lucrative for the average citizen to be on Government welfare than if they actually got a job. This only increases the tax burden on thoose who continue to work.


I know several people in exactly this situation.  With all the taxes I pay on payroll tax, social security FICA, gas tax, property tax, sales tax, state tax, federal tax, vehicle license tax, vehicle tax, etc., I am lucky if i actually take home 35% of my pay, and am seriously considerng taking early retirement and living off social security. 


Very sad indeed. 

Feb 11, 2013 5:59PM
How about NO ONE PAY for ONE YEAR. Then see how they like stealing our money as they do for worthless projects and congrsssional raises they have'nt earned.
Feb 11, 2013 11:11PM

What turned me off years ago was a mutual fund I owned that was barely treading water

when the market was having a great year.When they did their capital gains in December

I reinvested the capital gains and the IRS said I made $16,000 I had to pay taxes on.An

index fund would have avoided that situation.

Apr 14, 2013 7:36PM

"Does this form mean I don’t owe that debt anymore?


Not necessarily. If the form was filed because you haven’t made payments for three years and they haven’t tried to collect recently, then you may still owe the debt."

Can someone explain that for me?

I think I'm too stupid to understand the logic of how an official tax document can falsely say that a debt has been forgiven, when in fact the debt has not been forgiven.

It's just like when employers issue their employees W-2 forms every year so that employees may file their taxes on a 1040 tax form.

Section 1 on a 1040ez tax form, for example, instructs the person filing their annual taxes to enter their "Wages, salaries, and tips. This should be shown in box 1 of your Form(s) W-2." We've all most likely submitted one of these at our current or previous job.

However, if an employee made $50,000 as indicated by box 1 of their W-2, and subsequently submits their 1040ez to the IRS with "$0.00" in section 1 instead of the $50,000 they actually earned, I'm pretty sure everyone is in agreement that there's a problem with that.

So, why should a Creditor be treated any differently from the person submitting a tax form with false information?

The way I see it is if a creditor gives someone a 1099C, and then not following the rules required to even issue the thing in the 1st place, it's the equivalent of picking certain parts of the Bible you choose to believe in while dismissing the rest of the Bible.

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