This article was originally posted on the bankruptcylawnetwork.
This year, it seems that more creditors than ever are sending IRS Form 1099-C to their debtors who have filed bankruptcy or settled debts with them. While in many cases it is unnecessary for the creditor to do this, it is nothing to fear. If a debt is discharged in bankruptcy, it is not treated as cancellation of indebtedness income, and it is not taxable. The IRS has provided a simple fix for the seemingly unnecessary 1099-C: Form 982.
If you have received a 1099-C, you need to file IRS Form 982 to demonstrate to the IRS that it is not taxable. While it seems complicated, it is very simple with regard to consumer debt discharged in bankruptcy, and even do-it-yourself tax filers should be able to do it. You just need to check box 1a on the form (“Discharge of indebtedness in a title 11 case” — “Title 11″ being the Bankruptcy Code, not to be confused with Chapter 11, which is just one type of case under Title 11). You then list the amount discharged on line 2, and then list it again on Line 10a to reduce the basis in your property. However, only list it on 10a to the extent the basis (generally, the purchase price) of the non-depreciable property that you retain after discharge exceeds the debt remaining after your discharge (which includes both existing mortgages and loans secured by property you still own and any non-dischargeable debt). This reduction in basis can result in capital gains tax liability in later years, but because of the residential capital gains exclusion, for most people it has no effect.
This “reduction in attributes” can be more complicated for business debt: for that, you should to consult your tax advisor.
Why is it that these forms are issued? The idea that cancellation of indebtedness is income is pretty simple, and is designed to avoid what could otherwise be a great way to defraud the IRS: instead of getting paid money that would be income, you could “borrow” the money (because a loan is not income), and then have the “lender” just write off the “loan”. To avoid this scam, the tax law generally treats cancellation of debt as income.
To avoid creating phantom income when there is no scam, but legitimate debt cancellation for non-fraudulent reasons, there are certain exceptions to the treatment of cancellation of indebtedness as income. The most important for consumers are (a) discharge in bankruptcy; (b) insolvency; and (c) qualified principal residence indebtedness.
• Debt discharged in bankruptcy is simply not income for cancellation of indebtedness purposes.
• Debt cancelled to the extent of a taxpayer’s insolvency is not treated as taxable income. Generally speaking, this means that if all of your liabilities exceed the fair value of all of your assets (including exempt assets and retirement plans), cancellation of indebtedness up to the amount by which you are insolvent is not taxable (once rendered solvent, the balance would be taxable).
• Finally, through the end of 2012, cancellation of secured loans used to buy, build or substantially improve your principal residence, or to refinance loans incurred for those purposes, is not taxable.
Even though cancellation of indebtedness may not be taxable, the law in many cases requires, or permits, creditors to issue Form 1099-C to report that cancellation to the IRS. The IRS regulation (26 C.F.R. 1.6050p-1(a)(3)) states “Except as otherwise provided in this section, discharged indebtedness must be reported regardless of whether the debtor is subject to tax on the discharged debt under sections 61 and 108 or otherwise by applicable law.” In other words, the fact that you get a 1099-C from a creditor does not mean that you owe tax on the money shown on the form. That is the reason for the Form 982.
There are exceptions to reporting. In particular, where a debt is discharged in bankruptcy, the IRS does not require issuance of a 1099-C unless it was incurred for business or investment purposes. Cancellation or discharge of consumer debt in bankruptcy need not be reported on a 1099-C. But it can be.
A few words of caution: if the debt, or part of it, was cancelled before you filed bankruptcy (through debt settlement or negotiation, for example), the creditor must issue the 1099-C unless another exception applies. And that debt is not included on Line 1a of Form 982, because it was not discharged in bankruptcy. As a result, even if you later file bankruptcy, you may owe tax on that debt cancellation income unless you were insolvent at the time you settled it. For that reason, it may make sense not to settle your debts but to just file bankruptcy and discharge them. Before entering into a debt consolidation or settlement program, or settling claims asserted against you, it is important that you discuss the tax aspects of your situation with an experienced bankruptcy attorney.