How Not to Pay Taxes on Your Cancelled Debt

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Did you get a 1099-C in the mail?  Not sure what to make of it?  Well first thing you ought to know is that you should immediately get a copy of IRS Form 982.  I’ll explain later but it has to do with not paying taxes on your 1099-C.

What’s a 1099-C?

If you got one in the mail, you might be feeling either a little confused or a little worried.  After all, anything reported on a 1099 is income.  Income means income tax.  Yikes- how is it that you had all this “income” but never saw any of it?  Well the answer is that 1099-C is used by lenders to report Cancellation of Debt.  If you formerly owed money but now you don’t, for whatever reason, you might get a 1099-C in the mail from your lender.  This will happen when the amount of cancelled debt is over $600.

How do you get your debt cancelled?  Well for starters you could negotiate with your lender to pay off the loan for a smaller amount than the original amount of the loan.  The amount you negotiated away is considered cancelled debt.  If it’s more than $600 you get yourself a nice 1099-C in the mail come tax time.

Another reason you might get Cancellation of Debt income is because you sold your home in a short sale.  That’s when your mortgage holder agreed to take less than the full amount of the loan for the sale of the property.

Likewise, if you went into foreclosure and there’s a balance due on that went unpaid, it’s cancellation of debt.

1099-C Means Income Tax But IRS Form 982 Might Help

The IRS will get a copy of your 1099-C too, and will look for that “income”to be reported on your tax return.  However, there are some situations where you don’t have to pay income tax on it.  You would use IRS Form 982 to tell the IRS why you don’t have to pay income tax on your cancelled debt.

Reason #1

The Mortgage Debt Forgiveness Tax Relief Act.  For years 2007-2013, any debt reduction through refinancing or foreclosure, qualifies for exemption from income tax, up to $2 million.  It must be your principal residence

Resason #2

Bankruptcy.   If you declared bankruptcy then your debt cancellation is not taxed.

Reason #3

Farm Debt.  If you ran a farm and had debts cancelled, you may not have to pay income tax on the 1099-C.

Reason #4

Insolvency.  This reason is sometimes confusing to taxpayers.  Insolvency means when your debts total more than what you are worth… your assets.

Reason #5

Non-recourse loans.  This type of loan is one which if you don’t make your payments, the only thing the lender can do is take back the property.   They can’t come after you personally, in a legal sense.  Sometimes mortgages are non-recourse loans.

If you really want to dig into this subject, IRS Publication 4681 is the complete guide to Canceled Debts, Foreclosures, Repossessions, and Abandonments.  This is a comprehensive guide used mostly by tax professionals.

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