Many people every year receive 1099-C form in the mail and have no idea what to do with it. For starters, don’t ignore it. 1099-C is a Cancellation of Debt form that every creditor who forgives (cancels) a debt of $ 600 or more must file with the IRS. In fact, IRS every year processes millions of these forms. The reason that you might get a 1099-C is that the IRS considers the amount of debt forgiven or cancelled as income and you must include it in your gross income while filing your income tax return. Hence, Cancellation of Debt income can modify your tax bill and refund amount.
Some situations where you can expect to receive a 1099-C are: your creditor and you have mutually agreed to settle the debt for an amount that is less than what you owe and the creditor has forgiven the rest of the amount; your home is foreclosed and there is negative home equity (fair market value of your house is less than the debt owed) such that the difference amount is cancelled by the creditor; deficiency arose due to the short sale of your house is forgiven by the creditor; or for the last three years or more, you have made no payment on the debt and the creditor also hasn’t made any appreciable collection efforts for the past 12 months.
The IRS 2014 Publication 4681 mentions certain exceptions where you are not required to include Cancellation of Debt amount in your gross income. These exceptions are: debt forgiven as a gift, bequest, devise, and inheritance; certain student loans that meet specific conditions; deductible debt used under the cash method of accounting; and price reduced by the seller after purchase. Exclusions are applied once you have used the exceptions mentioned above. The exclusions mentioned in the IRS 2014 Publication 4681 are: debt cancelled through bankruptcy; insolvency; qualified farm indebtedness; qualified real property business indebtedness; and qualified principal residence indebtedness.
of the aforementioned exclusions, discharge through bankruptcy is the most common method to avoid cancellation amount to be added to your gross income. Hence, if a debt is discharged under the Title 11 of the U.S. Bankruptcy Code (Chapter 7, Chapter 13, etc.), then your creditor cannot send a 1099-C form to you. You are required to mention this bankruptcy discharge in another form known as Form 982. It is important to mention here that if you file bankruptcy after you have received 1099-C, then your creditor still has right to send you 1099-C.
The solution to the above mentioned problem is to show that you were insolvent at the time your debt was forgiven and you could avoid to include the cancelled amount to your gross income. This essentially means that you will have to prove that immediately before the time of cancellation, the fair market value of all your assets was less than the total amount of debt (liabilities) you owed. If the amount by which you were insolvent was higher than the forgiven amount, then you can remove this entire forgiven amount from your gross income; however, if the amount by which you were insolvent was smaller than the forgiven amount, then you have to include the difference amount to your gross income and must show it on the Form 1040 and the insolvency amount on Form 982.