Many of our Clients receive or are expecting to receive a 1099 form in the mailbox from Creditors that have or will be forgiving credit card debt.
The Creditor may have forgiven the debt as part of a settlement or just forgave it because it made sense.
The 1099 form the creditor issues to you isn't a good thing. It tells the IRS that the credit card debt was forgiven and that the forgiven portion is now taxable income. If you fail to list it on your tax return as income the IRS will change your return and add it. It will then send you a bill.
If you have negotiated a settlement with a credit card lender, or one just forgave a debt without your input…you should be concerned about the potential tax liability.
Here are 3 ways to avoid the liability:
If the debt obligation was discharged in a bankruptcy case, it can't be counted as taxable income. My Arizona clients often weigh out whether it makes more sense to try and settle credit card debt or whether it makes more sense to file for bankruptcy.
In making that decision, the ability to treat the debt as non-taxable as a result of the bankruptcy filing has to be taken into account.
If you are sent a 1099 for a debt that was discharged in bankruptcy and the 1099 was issued after the filing of the bankruptcy, talk to your accountant about a form 982 to use with your tax return. This form tells the IRS that the discharged debt isn't taxable.
If you were “insolvent” just before the debt was forgiven, the debt is tax free to the extent of the insolvency. If the debt was greater than your assets by $50,000.00 at the moment before the forgiveness occurred, you would be able to have $50,000.00 of the debt forgiven and avoid tax on it.
The form 982 is key here again. If you don't file it with the return, the IRS will treat the debt as income.
3. Principal Only
Only the forgiveness of the principal portion of the debt is taxable…. not the interest.