You\’d think that once you\’ve managed to discharge or repay most of your debts that would be the end of your financial worries. Unfortunately you\’re kind of wide of the mark there because the IRS, in their infinite wisdom, has figured out a way to tax your debts! In a way we almost admire their fiscal cunning when it comes to this type of stuff, but we\’d prefer to see that same cunning put to better use in taxing those who need to be taxed and assisting those who don\’t…but we digress!
When you\’ve restructured your finances you could very well be due to pay something called a tax on forgiven debts, or tax on Cancellation of Debt Income. Basically how it works is that any money received through debt forgiveness (i.e. money you didn\’t have to repay) is viewed as taxable income by the IRS. You would probably assume that this only relates to large sums of cash but if you receive any more than $600 in \”income\” through debt forgiveness your lender will need to file a 1099-C and send it to the IRS.
A 1099-C is used to report any Cancellation of Debt Income, with one copy of the form being sent from the lender to the IRS and another copy being sent to you. The most common reasons for having to file a 1099-C are that you negotiated a way to pay less of a debt than you actually owed with the creditor forgiving the rest, a home you owned went into foreclosure and the home is now worth more than what you originally owed on it, or that you haven\’t actively made any payments on a debt for more than 36 months, and there has been no active attempt by the creditor to collect on that debt within the last 12 months.
There are also 4 main reasons why you might be exempt from this type of income tax, which are as follows:
1. Insolvency – this happens when your liabilities exceeded your assets when the debt was forgiven. This exemption typically applies to low income families who are more likely to automatically become insolvent, as are those individuals who have very high debt loads. If you are currently insolvent you this implies that you have no disposable income, meaning you have no ability to pay any taxes from any income sources.
2. Forgiven debt interest and fees.
Any interest or fees pertaining to a forgiven debt are tax free and cannot, and should not, be included on 1099-C form.
3. Filing for bankruptcy.
You will obviously need to check this with your bankruptcy attorney but generally speaking if you are currently filing for bankruptcy this makes you exempt from any taxes on forgiven debts because most of your debts are about to be either discharged or restructured.
4. Purchase fraud.
Any purchases which were made fraudulently, for any reason, are also exempt from this form of tax. This also includes any disputed debt exclusion.
To file for exemption from taxes on Cancellation of Debt Income you will need to file form 982, which will also include situations where a creditor has accidentally included income to be taxed which is totally exempt from that process e.g. interest and fees on debts.
The above information is only for educational purpose, and that if you want professional advice on your taxes, the IRS and how to file forms properly please consult either a fully trained and qualified tax attorney or your CPA – or both at the same time.