Does Cancelled Debt on the 1099-C Have to Be Reported as Income?

Debt cancellation occurs through debt settlement when debtors resolve delinquent accounts for less than the full balance. Debt settlement harms credit scores but is helpful for eliminating excessive debt and is an alternative to bankruptcy. The website SmartMoney reports that settlement offers on credit card debt range from 20 to 70 percent of the balance, creating terrific savings for the debtor. On the downside, the IRS usually treats savings through debt settlement as income. Debtors receiving a 1099-C form after debt settlement must report the information.

Considerations

Potentially higher tax bills are a hidden cost of debt settlement. Settling $20,000 in credit card debt for $4,000 yields a savings of $16,000. The IRS then would treat the $16,000 as income, offsetting some of the settlement savings. Timing is an issue as well. People settling debt late in the year could face a higher tax bill just a few months later in April, when filing their federal income tax returns. A better strategy is to settle early in the year to allow the debtor 15 months--until April of the following year--to prepare for any possible tax consequences.

Process

Federal law requires creditors and debt collectors to issue Form 1099-C, Cancellation of Debt, whenever they settle debt resulting in a savings of $600 or greater. The creditor or debt collector must mail a form to the debtor and also send the information to the IRS.

Responsibility

The IRS maintains that debtors are responsible for reporting settlement savings even if the debt collector or creditor does not send a 1099-C. People who fail to report debt settlement savings could face penalties from the IRS.

Exemptions

Not everyone receiving a 1099-C for cancelled debt pays taxes on debt settlement savings. The IRS waives additional taxes on settlement savings for taxpayers who declare they were insolvent at the time of the settlement. Insolvency means a person has more debts than assets--often the case with people with thousands of dollars in credit card debt and other obligations and no valuable assets such as real estate. Debtors requesting special consideration becuase of insolvency can file IRS form 982 with their tax returns.