This time of year I routinely get inquiries about forgiven debts and the dreaded form 1099. As a general proposition, the tax laws create an obligation to pay tax whenever the taxpayer’s finances improve. For example, a paycheck improves my financial position and creates an obligation to pay tax on that income. With a paycheck the taxes are taken out directly and remitted by my employer. With that in mind, if I owed $30,000 but was able to resolve the debt by paying $5,000 I would have improved my financial position and might assume I would owe tax on the $25,000. Whether I owe the tax depends on my circumstances. A couple examples of forgiven debt provide context before I delve into the rule and its exceptions. Debts can be forgiven in several ways, the most common being settlements and bankruptcy. In a settlement the lender agrees to accept a sum of money to resolve a debt. Generally the amount will be in the range of thirty to sixty cents on the dollar of the balance owed. That means a $5,000 debt might be settled for $1,500 to $3,000. Upon payment the borrower will have no further obligation to the lender. Settlements are common when the original debt was for a credit card or personal loan. Bankruptcy can allow a person to pay little or nothing and have no further obligation to the lender. The bankruptcy system refers to forgiven debts as having been discharged. Regardless of the terminology, the point is the money is no longer owed. That may seem like the end of the story but later the borrower may get a 1099. Form 1099 reflects cancellation of debt by the lender, it does not create a taxable event. In fact, very few people should pay the tax. Unfortunately many people prepare their own tax returns and mistakenly pay the tax. The IRS cheerfully accepts the money! The rule making cancelled debt taxable has two major exclusions discussed below.
1. The debt was forgiven in bankruptcy. This requires filing bankruptcy and obtaining a discharge from the bankruptcy court.
2. You were insolvent when the debt was forgiven. This does not require a bankruptcy. It means your debts exceeded the value of your assets at the time the debt was forgiven. The IRS rarely challenges a claim of insolvency.
Either of these exclusions will render the forgiven money non-taxable, you do not need both. All you need to do is attach IRS form 982 to your tax return to clarify why the income reflected in the 1099 is nontaxable. The exceptions are also discussed in IRS form 982 and IRS publication 4681 which can be found on the IRS website at www.irs.gov.
At the Law Office of Michael Primus we have helped thousands of clients get out of debt, stop wage garnishments, and start fresh through bankruptcy. If you live in Contra Costa, Alameda or Solano counties and have debt problems, contact us for a free in-office consultation. We have offices in Walnut Creek, Antioch, and Hercules.