Canceled Charge-Off
In some circumstances, the creditor may decide to cancel the debt completely. When this happens, you no longer have a responsibility to pay the debt. While you may be relieved to be free from this obligation, you may not be in the clear yet. The canceled debt may now become an issue to hash out with the IRS. When creditors cancel debts, they are required to report the canceled amount (if it’s over $600) to the IRS using Form 1099-C cancellation of debt. You’ll also receive a copy of the form in the mail, typically around tax time if it applies. You may not have personally encountered this tax situation before, but it’s pretty common. The IRS estimates nearly 4 million 1099-C forms will be sent to taxpayers in 2021. The IRS considers any canceled or forgiven debt as income. Like income from other sources, like your job or business, you’re required to report income from a canceled debt on your tax return for that year. Though you never actually received any extra money, a canceled debt does result in a change to your net worth. The additional “income” from your canceled debt could increase your tax liability, resulting in a smaller income tax refund or even a tax bill. Because the creditor has sent a copy of the cancellation of debt form to the IRS, the IRS is expecting you to include the amount on your tax return. Failing to include the amount may cause your return to be rejected or you may receive a bill from the IRS. If you receive the cancellation form after you’ve already filed your taxes, you may need to amend your tax return.
Settled Charge-Offs
You’re also required to include canceled debt on your taxes when a charge-off is settled because the creditor cancels a portion of the debt in the settlement offer. A settlement is when you negotiate with the creditor to pay just a percentage of the outstanding balance to satisfy the full debt.
Exceptions
You may be able to get an exception for including the canceled debt as taxable income on your tax return. One such exception pertains to insolvency. If you were insolvent, meaning you had a negative net worth, at the time the debt was canceled, you might not have to report all or part of the charge-off to the IRS. To claim the insolvency exemption, you must file IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. For this, you’ll need to have a list of your assets and liabilities at the time the debt was canceled. If you’ve already paid taxes on the canceled debt and later realize you qualified for the exception, you may be able to file an amended tax return to receive a refund of your overpayment. Also note that there are certain other exceptions for bankruptcy, student loan debt, and farm and business real estate debt. For more information, you can visit the IRS website to view the rules and instructions related to the cancellation of debt.
Get a Tax Preparer Involved
It’s always in your best interest to seek the help of a tax professional, especially when you’re dealing with unfamiliar tax situations and forms. The tax preparer can help ensure your taxes are filed correctly whether that means including the canceled debt as income or filing for the insolvency exception.
