Questions start when you receive a Form 1099 from a creditor.
Tax on cancelled debt
Debt may get cancelled in a short sale; by lender compliance with a settlement agreement with the feds; in a bankruptcy; or in a foreclosure.
Lenders and debt collectors believe themselves bound to send out a 1099 whenever they handle a transaction that may implicate cancellation of debt. They aren’t rendering an opinion on the tax treatment of the event. They are just reporting it to the IRS.
Receipt of a 1099 is not the final word on the topic, only notice that the transaction in question has been reported to the IRS.
Cancellation of debt “income”
The standard rule is that debt that is cancelled is treated as though you had received that much cash, and that pseudo-cash is treated as income. And, if it’s income, the IRS thinks it’s taxable.
The exceptions to recognizing that transaction as income found in IRC 108 include
- insolvency at the time, and
- discharge of the debt in bankruptcy.
You have to file an IRS form to rebut the 1099. It’s form 982 and right at the top are the boxes to check to invoke the exceptions.
The form also includes a worksheet to see if you are insolvent for the purposes of this provision of law.
Remember, too, that if you did not have personal liability for the debt, the cancellation of that debt is not even forgiven debt. There was no debt.
You may have no personal liability because of a previous bankruptcy or by reason of California’s anti deficiency laws.
Also, there is special legislation dealing with cancellation of debt upon loss of a primary residence, excluding phantom income from qualifying transactions.
Here’s the IRS on the subject: http://www.irs.gov/taxtopics/tc431.html
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