If you received a 1099-C from a creditor, you have had cancellation of debt in the past year. Any unexpected tax form, especially one that adds income like a 1099, is cause for concern. What is a 1099? Basic tax policy is that anytime someone can deduct some amount, for someone else, somewhere it is an income event. A 1099 is an informational filing with the IRS. It tells them of revenue that might otherwise be lost in the shuffle.
The money that a 1099-C reports is from, “cancellation of a debt.” The tax code has always stated that whenever a lender cancels an obligation, that portion that they will not collect is a discharge of indebtedness income or “DOI” to the party owing the money. Your lender wants to benefit. On their side is a deduction. On your side is income. Our hungry governments want to make sure they get every dime in taxes they can. Even if it is on a gain that you never saw, touched or got to spend. Don’t you just love America!
There are a whole lot of ways you can have this, and be the happy recipient of your very own 1099-C:
1. Interest that is forgiven. If any non-deductible interest is forgiven, the interest must be included as discharge of indebtedness income in the year it is discharged
2. Loan Modifications and Discounts. Anytime your lender offers to discount or reduce your principal balance of any type of loan, or a loan modification, the amount of the discount, or modification is DOI income. This is the case whether or not you are personally liable for the debt.
3. Property that is sold, foreclosed or repossessed. If property is sold at foreclosure or repossession sometimes the lender will cancel the debt to write off the deficiency. This creates DOI income you are responsible to include as income.
4. If you abandon property. If you just walk away from property and the lender cancels the obligation, You just benefited from the cancellation and you will have to pay tax on the DOI income.
5. If you are a stockholder in a corporation and the corporation forgives money the corporation owes you, you have DOI income in the year it was discharged, or forgiven.
You have just discovered the nasty little secret of short sales, loan modifications, and debt settlement companies. Everyone touts these as alternatives to filing bankruptcy. Everyone other than those in the know.
Many times I will have a client come in for consultation who wants to sell his home short. Ready to pay taxes on the amount the bank walks away from? Go right ahead. You might even get to pay up to half of all the money you “saved” from selling short to all the governments who take your tax money.
Filing Bankruptcy is a far better choice. When you discharge the obligation in a bankruptcy, you then file IRS Form 982. This is a form entitled “Reduction of Tax Attributes Due to DOI.” If it is discharged in either a chapter 7 or a chapter 13 bankruptcy, any 1099-C cancellation of debt by the lender is not an income event for you, even if they send a 1099-C.