1099-C: ‘Cancellation of Debt’ tax form confuses
By Peter Fullam
March 8, 2016
Although 1099-Cs have been around for decades, many taxpayers still don’t have a clue what to do when they receive a “Cancellation of Debt” form at tax time.
Confusion surrounding the IRS 1099-C tax form is a problem the Taxpayer Advocate Service has been grappling with for years. That confusion starts with the title of the form — “Cancellation of Debt,” as well as the purpose of the form — notifying a taxpayer that he or she owes tax on a canceled debt amount.
Generally, if a lender cancels or forgives $600 or more of a debt, the IRS considers that canceled debt as income, and the borrower may owe taxes on the money. As a result, millions of people who negotiated a debt settlement on a credit card balance may be shocked to discover that they owe the IRS for their written-off debt.
“The notion that canceled debt generates taxable income is not intuitive and comes as a baffling and unwelcome surprise for many taxpayers,” National Taxpayer Advocate Nina E. Olson says.
“A large percentage of taxpayers with canceled debts qualify under one of the exceptions, but given the complexity of the rules, it’s extremely difficult for taxpayers to determine which exemptions, if any, apply,” she adds.
These exceptions would save a taxpayer from having to claim the taxable amount as income on their tax returns.
“The first thing to do when you see your 1099-C is don’t panic.”
— Lynn Ebel
of the Tax Institute
at H&R Block
An estimated 6.5 million 1099-C forms are being mailed for the 2015 tax year, up from 6 million for 2014. That number is projected to reach 6.8 million in 2016. The number is expected to hit 8 million in 2023
“This area of taxation is truly a trap for the unwary and ultimately may cause taxpayers to pay tax they don’t owe,” Olson says.
Finding exceptions gets complicated
The 1099-C challenges not only taxpayers but tax preparers.
“Unfortunately, most of our clients, and most tax preparers are not familiar with the form,” says David King, chief executive officer of Optima Tax Relief, a Santa Ana, California-based tax advisory service. “So they might not include it with their tax returns, which exacerbates the issue.
“So what happens is they file their taxes, and they get a refund,” says King. “Then all of a sudden, ‘wham!’ The IRS is going to hit them. ‘Oh, here’s a 1099 you did not include in your tax return, and now you owe another $4,000 with interest and penalties.’”
The 1099-C covers home mortgages, car loans, credit card debt, short sales and the whole range of lending vehicles.
Figuring out what qualifies for an exemption for not having to pay additional taxes generated by the 1099-C income — and there are several of these exceptions — can get complicated.
For instance, there’s an exemption for debt forgiven on a principal residence due to foreclosure. But if the home has been refinanced to include credit card debt, an auto loan or other debts, those can’t be counted. It also doesn’t apply to investment or vacation homes.
Other exceptions and exclusions include: student loans that are forgiven if the student works “for a certain period of time in certain professions for a broad class of employers;” debt that is canceled as a gift; and for debts discharged in bankruptcy.
Another exception: If you were insolvent immediately before a debt was canceled, debt should not be counted as income to the extent that your liabilities exceed your assets. So if your liabilities are $2,000 greater than your assets, you can exclude that amount of cancellation of debt income.
“This actually helps a lot of clients,” says Lynn Ebel of the Tax Institute at H&R Block. “It involves quite a bit of homework. You review your assets, the fair market value of your household furnishings, and your vehicle and things like that. But it’s definitely worth it.”
The IRS says it granted 1099-C exceptions and exemptions amounting to $39.6 million in 2013.
“The notion that canceled debt generates taxable income is not intuitive and comes as a baffling and unwelcome surprise for many taxpayers.”
— Nina E. Olson,
National Taxpayer Advocate
But making sense of the forms is tough for everyone. Some lenders fail to file the forms, and some forms are incorrect or arrive years later.
“The ‘poster child’ for complexity (in IRS rules) is Cancellation of Debt Income,” Olson said in her Dec. 31, 2008, annual report to Congress.
It is so complicated, the National Taxpayer Advocate’s 2007 annual report notes that IRS temporarily decided its Volunteer Taxpayer Assistance sites, Tax Counseling for the Elderly sites and the IRS’s own Taxpayer Assistance Centers couldn’t address 1099-C issues.
Fast-forward to 2016, and not much has changed.
“I would definitely agree there can be substantial complexity in this area,” says Ebel. “Cancellation of debt is one of the large tax events that occur during the year that have potential to give ‘sticker shock’ to taxpayers when they see how much their tax bill is affected by it.”
“Cancellation of debt is not like other kinds of income”
One of the controversial aspects of the cancellation of debt tax is that it can seem like hitting a person while he or she is down. The 1099-Cs commonly go to people who were so far in debt that their lenders agreed to let them off the hook for all or part of the debt.
Consumers who have settled their debts have been through difficult negotiations with lenders and often think their issues with the debt are in the rear-view mirror.
“But there’s the fine print,” says Ebel. “A tax form is going to come in their name. And they’re just kind of really surprised because they think, ‘We took care of that’ and ‘I don’t think of that as income. I just don’t owe them anymore.’”
The Taxpayer Advocate Service continues to pressure the IRS to simplify its rules for handling the 10-99-C form. A simple one-page cover letter with the 1099-C form explaining it in plain English, so an immigrant could understand it, has been suggested as a step in the right direction.
“The first thing to do when you see your 1099-C is don’t panic,” says Ebel. But, she adds, you may need the help of a tax professional.
“Cancellation of debt is not like other kinds of income, when taxpayers physically receive income,” says Ebel. “And, of course, there is no withholding to offset taxes against it.
“This would be one reason why you would want to see a qualified tax professional to make sure you claim an exclusion that you qualify for, or at least understand what exclusion or options you have if you have canceled debt this year.”