How to Handle Cancelled Debt

Handling cancelled debt is a straightforward process for debtors and creditors. Debt cancellation occurs when a creditor and debtor agree to resolve a delinquent account through debt settlement. Usually, the creditor agrees to settle the account for less than the full balance, creating a savings for the debtor. The solution is often favorable for both parties. The creditor resolves a delinquent account that appeared to be noncollectable, and the debtor pays off a bad debt affecting his credit rating.

Instructions

1

Check the amount of the debt cancellation. As of 2011, creditors and debt collectors must report the transaction to the Internal Revenue Service if the debt cancellation creates savings of $600 or greater for the debtor. For example, a debtor may settle a $20,000 debt for $15,000. That's a savings of $5,000, and in most cases the IRS will treat that as income for the debtor.

2

Mail IRS Form 1099-C, Cancellation of Debt (see Resources) to the debtor and the IRS if you are the creditor and the transaction resulted in a savings of at least $600 for the debtor. Generally, credit card companies, banks and other lenders engage in debt settlement discussions leading to debt cancellation. However, the same tax rules apply to individuals and small-business persons settling debts, such as a plumber settling with a homeowner on an old debt.

3

If you are the debtor, include information from the 1099 form on your federal tax return -- if your savings was $600 or greater. The IRS requires you to supply the information even if you did not receive a 1099 from the creditor.

4

Ask the IRS for an exemption if you are the debtor and you were insolvent at the time of the settlement. A debtor who has more debts than assets is financially insolvent under IRS guidelines and does not have to treat debt settlement savings as income for tax reporting purposes. Apply for insolvency by submitting IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (see Resources). Submit the form with your federal tax return.