Cancellation of Debt and Tax Consequences

What is the difference between a 1099A and a 1099C?

With the recession continuing, so many borrowers received a 1099A and/or a 1099C due to foreclosure, mortgage debt cancellation, and credit card debt cancellation. According to the IRS, it received fewer than 1 million debt cancellation forms in 2003, compared to more than 3.9 million in 2010. The IRS expects to receive 6.4 million debt cancellation forms in 2012. There is so much confusion and misinformation about the tax implications of a 1099A and a 1099C from foreclosure and cancellation of debt. So let’s take a look at these forms and see what the differences are and how to avoid tax liabilities when you receive such forms.

What is a 1099A?

When the borrower abandons real or secured personal property, the creditor may have to issue a 1099A to the IRS and send a copy to the borrower. According to the IRS 1099A instructions, “abandonment occurs when the objective facts and circumstances indicate that the borrower intended to and has permanently discarded the property from use.” Please remember that receiving a 1099A does not mean that the debt is cancelled. The 1099A is simply a notice from your creditor to the IRS that the borrower abandoned the property, thus, it does not create the tax liability yet.

What is a 1099C?

A 1099C is the form that financial institutions use to report the cancellation of debt to the IRS. The borrower who received the copy of the 1099C from the financial institution may have to report the amount showing in the 1099C as an ordinary income and pay taxes which can be a significant amount. If the borrower abandoned the real estate, eventually ended up in foreclosure, and it resulted in a cancellation of debt, then that foreclosure maybe a taxable event and the borrower may receive both forms (1099A and 1099C). Also, the 1099C can be derived from successfully resolving the credit card debts. For example, a person with $15,000 in credit card debt who negotiates to pay only $7,500 of the balance would have $7,500 in forgiven debt as an income. From the bank’s perspective, it’s not their job to give tax advice, so generally the bank or credit card company does not disclose that a 1099C would be coming after the settlement of debt. Therefore, the borrowers who received the 1099C or in the process of a debt cancellation should immediately consult with a CPA.

How to avoid tax consequences?

As stated above, a 1099A does not mean that the borrower owes taxes, but a 1099C may. However, there is hope for the borrowers who are already having financial difficulties and received a 1099C. There are generally three ways for the borrowers to have their debt cancelled and avoid tax liabilities.

First, if the principal residence is lost in foreclosure, which resulted in cancellation of the debt, then generally up to $2 million is not taxable because of the Mortgage Forgiveness Debt Relief Act of 2007.

Second, if the borrower was insolvent (meaning liabilities exceed assets) at the time the debt was cancelled, then, the borrower is not liable for taxes on the cancelled debt. However, this applies only up to the amount by which the borrower is insolvent. That means if $100,000 in debts were forgiven by the bank and liabilities exceeded assets by $60,000, then the $60,000 would be excluded as income, but the remaining $40,000 would be reported as an income to borrower. In order to demonstrate the insolvency, the borrower should file the IRS Form 982 with the tax return in the applicable year. Third, there could be no tax liabilities if the debt was cancelled as a result of a bankruptcy filing.

Conclusion

Dealing with debt collectors is not a very pleasant experience for borrowers. After months of fighting with the debt collectors and finally the debts were cancelled, then, they now have to deal with an even bigger problem, the tax collectors. Please consult with your CPA if this is your case.

If you have questions, need additional information or would like to discuss more on the above topic, please feel free to call us and/or visit our office.