Cancelled or Forgiven Debt in California? The IRS May Consider It Income and You May Owe Taxes
If you’ve fallen significantly behind on your debts, you may engage in negotiation with creditors to reduce or eliminate certain parts of your debt burden. In certain situations, the potential for bankruptcy and the possibility of an overworked creditor may encourage them to forgive a certain portion of the debt. Other times the creditor may simply realize that the collection costs will exceed any amount that can be recovered. While having debt forgiven or cancelled is certainly a positive step toward repairing one’s personal or business finances, it may come with certain strings attached. The IRS may consider the forgiven debt to be income and tax the amount.
The strategic lawyers of the NewPoint Law Group can assist California taxpayers with a variety of tax issues including the effects of cancelled debts. Our Roseville, Sacramento, and Folsom law offices can provide on-point advice and guidance regarding how to approach complex tax and financial issues. To schedule a confidential consultation, call us at 1-800-358-0305 or contact us online.
Why Did I Get a 1099-C and What Does It Mean for My Taxes?
Generally speaking, if you borrow money and have a legal obligation to repay the loan or advance in a certain amount, it is the definition of being indebted. If the debt that you owe is forgiven, reduced, cancelled, or otherwise settled for an amount less than what you agreed to repay, you may be subject to imputed income in the amount of the cancellation of the debt. Canceled debts can occur in a broad array of circumstances and may include credit card debt, the repossession of a vehicle or other property, the abandonment of property, a mortgage modification, or the foreclosure of a home.
More than likely, the amount of the cancelled debt is typically taxable. This gives rise to both a tax reporting and tax payment obligation. The lender or holder of the debt will frequently submit a 1099-C to both the beneficiary of the forgiven debt and to the IRS.
The 1099-C, Cancellation of Debt, will show the date the debt was cancelled, the amount of debt that was cancelled, the affected taxpayer, and a multitude of other information. This means that you must report this cancelled debt as income and pay taxes on the amount when filing your income tax return.
What Are Exceptions to Cancellation of Debt Income?
There are certain exceptions requiring forgiven debts to be treated as taxable income. To start, any debt cancelled as a gift is an exclusion to the rule. Additional exceptions include cancellation of qualified student loans under a work-forgiveness provision, debts that would have been deducible if paid, qualified purchase price reduction given by the seller of property to the buyer, and certain cancellations under the Home Affordable Modification Program.
In other cases, cancelled debts can be excluded from being counted as imputed income. This would occur when debt is cancelled due to insolvency, debt cancelled in Chapter 11 bankruptcy, cancellation of certain qualified farm debts, cancellation of certain debts relating to a qualified principle residence, and the cancellation of qualified real property business indebtedness.
New IRS Final Rule Affects Partnerships and Disregarded Entities with Discharged Debt
The newly issued IRS final rule slightly complicates the analysis for certain businesses like grantor trusts, partnerships, and other disregarded entities. Under the rule, the analysis will apply at the partner level for discharged debts; that is, the applicability of Section 108(a)(1)(A) and (B) of the Tax Code is applied and tested for each partner to whom the cancellation applies. Furthermore, the final rule also makes clear that the insolvency exclusion will only apply if the individual owner has filed for bankruptcy and the case is under the guidance of a bankruptcy court.
Work with a Sacramento Tax Attorney when Debt Has Been Discharged or Cancelled
If you are facing a situation where cancelled or discharged debt has affected your personal or business finances, or you are dealing with the IRS, consider the tax attorneys of the NewPoint Law Group. We can help you assess the situation, determine whether an exception or exemption applies, and advise you as to the proper way to proceed. To schedule a confidential tax consultation at our Roseville or Folsom law offices, call 1-800-358-0305 or contact us online.