Cancellation of Debt Income?

I am hearing from more and more of my clients about who have received notices concerning cancellation of debt income. Some have received a form 1099C, others have gotten notices from the IRS concerning the failure to include cancellation of debt income in a prior year’s tax return.

It is not unusual for debts which are in default to be settled for less than the amount due, by payment of a lump sum. Creditors often do this when they believe that they will have difficulty collecting the full amount. Debtors, particularly those who are not filing bankruptcy, may find this preferable to attempting to catch up by making payments.

The IRS considers the difference between what was owed, and what was paid to be income to the debtor, and requires creditors to report this whenever the amount exceeds $600.00. The debt must be reported as ordinary income on form 1040.

There are a number of situations in which the “income” is not taxed. These include:

● Debts discharged in Bankruptcy
● Debts resulting from the foreclosure of a principal residence, or under the Homeowners Affordable Modification Program
● Debts forgiven when the taxpayer was insolvent (debts exceed assets)
● Certain “qualified” farm debts
● Debts cancelled as a result of a gift or bequest
● For a cash basis taxpayer, debts the payment of which would be deductible

More information about this is available from IRS Publication 4681.

If an exception applies, it can be claimed on Form 982 , which should be filed with the tax return.

One question which the IRS does not discuss is the difference between debts that are cancelled, and debt which was the subject of a genuine dispute. For example, if I purchase a product from a company which doesn’t perform properly, I might refuse to pay for it. If I am successful in court, or if a settlement is reached, I would argue that the debt never existed, and therefore has not been cancelled. In a typical debt cancellation case, there is no real argument about the validity of the debt, merely a determination by the creditor that they will not be able to collect the full amount.

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