If you've gotten in over your head with credit card bills or other debts, your creditors might be willing to negotiate a settlement. This means the creditor agrees to let you pay a lump sum for less than what's owed and forgives the rest of the debt. The creditor will issue a Form 1099C and you'll need to report the canceled debt on your income taxes.
Issuing a 1099C
The IRS requires creditors and debt collectors to send out a Form 1099C when the forgiven debt exceeds a certain amount. As of 2012, a 1099C is required when the canceled debt is $600 or more. When you get your Form 1099C, you should check it to make sure the information is correct. The form should include your name and address as well as the creditor's name and address. The creditor is responsible for reporting the date the debt was forgiven, the amount that was forgiven, a description of the debt, and the amount of interest that was included, if applicable.
Reporting Canceled Debt
When you file your taxes, you'll need to report canceled debts on Form 1040. If the forgiven debt was a personal debt, you'll enter the amount on Line 21 under the Income section. If you had a business debt that was forgiven, you'll still enter it under the Income section on Line 12. You'll also have to attach a Schedule C or Schedule C-EZ for business debts. If you're filing Schedule C, forgiven debts are entered on Line 6. For Schedule C-EZ, canceled debts are entered on Line 1.
Exceptions and Exclusions
The IRS lets you claim exceptions and/or exclusions for certain canceled debts. An exception refers to a canceled debt that wouldn't normally count as income. Examples of exceptions include amounts that were forgiven as a gift or a bequest and debts that were canceled through a student loan forgiveness program. An exclusion allows you to remove certain canceled debts from gross income, even though they would normally be taxable. You can claim exclusions for forgiven mortgage debt, business debts, farm debts and debts that were canceled when you were insolvent.
If you're claiming an exclusion for a canceled debt, you'll need to complete Form 982, which might offset your asset basis, losses and other credits. If you're planning to claim an exclusion for insolvency, you can only exclude forgiven debt up to the amount that you were insolvent. For example, if you have assets totaling $50,000 and debts totaling $55,000, you could exclude up to the first $5,000 in forgiven debt but you'd have to pay regular income tax on the rest. This could end up pushing you into a higher tax bracket and significantly increasing your tax liability.
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