If you have recently received a 1099-C form from a creditor, you may have many questions about it. Due to changes in IRS procedures, more creditors are now sending out 1099-C forms at the beginning of the year. Many tax preparers assume that you always have to include these 1099-C amounts as income on your tax returns and pay taxes on them. However, in many cases that is not true.
A 1099-C now can be sent to you if a creditor stops collecting on a debt or “charges it off.” This can occur after a house is foreclosed or sold in a short sale, or if you receive a principal reduction as part of a loan modification. This debt reduction is sometimes — but not always — treated by the IRS as a type of income that you may have to claim as income on your tax return.
If your house was foreclosed or sold in a short-sale, you may have received a 1099-A form instead of a 1099-C form. The foreclosing lender (or a junior lender that was wiped out by a senior lender’s foreclosure) can use a 1099-A form to report a property transaction that consists of sale, foreclosure, or abandonment by the borrower. The lender reports the balance of the loan on the transaction date, along with the “fair market value” of the property on that date.
Box 5 is checked if the lender believes the borrower was “personally liable” for repayment of the debt. If the Box 5 is checked, that may cause the IRS to believe the difference by which the “balance of the principal outstanding” exceeds the “fair market value of property” is debt owed by the borrower. If that debt was listed and discharged in a bankruptcy, in most cases no income taxes would be owed by the borrower. On the other hand, if Box 5 is not checked, the IRS will likely believe that this is a transaction that may give rise to capital gains income.
The IRS now requires creditors to report debt (including unsecured debt like credit cards and medical debt) which they have given up collecting, even if the creditor has not formally “forgiven” it or “written it off.” Look closely at Box 6 and see if it has been marked with a C, G, or H. If so, this may be a problem for you and this type of debt may need to be included and taxed in your income, unless you filed a bankruptcy and listed it in your bankruptcy or unless you were insolvent (insolvent means that you owe more total debt than your assets are worth) at the time they gave up collecting from you.
But there is good news! If the debt is wiped out in bankruptcy, 1099-C income is not taxable under Sec. 108 of the Internal Revenue Code in most cases. Capital gains income – reported on 1099-A – is not wiped out in bankruptcy, however.
In addition, beware of debt management plans and credit counseling plans outside of bankruptcy. Unfortunately, some people who try to avoid bankruptcy by paying a lot of money to these companies, end up owing income tax on the debts that are forgiven in the plans. Again, filing bankruptcy prevents the debts that are wiped out from being taxed as income.
Determining whether 1099-C income or a 1099-A transaction is taxable is very complicated. You should talk with an accountant (CPA) or tax attorney to find out how you should deal with 1099-C or 1099-A reported transactions.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.