In Bankruptcy? Don’t Fear the 1099-C
Posted: 13 Feb 2011 03:49 PM PST
This year, it seems that more creditors than ever are sending IRS Form 1099-C to their debtors who have filed bankruptcy or settled debts with them.   While in many cases it is unnecessary for the creditor to do this, it is nothing to fear.  If a debt is discharged in bankruptcy, it is not treated as cancellation of indebtedness income, and it is not taxable.  The IRS has provided a simple fix for the seemingly unnecessary 1099-C: Form 982.

If you have received a 1099-C, you need to file IRS Form 982 to demonstrate to the IRS that it is not taxable.  While it seems complicated, it is very simple with regard to consumer debt discharged in bankruptcy, and even do-it-yourself tax filers should be able to do it.  You just need to check box 1a on the form (“Discharge of indebtedness in a title 11 case” — “Title 11″ being the Bankruptcy  Code, not to be confused with Chapter 11, which is just one type of case under Title 11).   You then list the amount discharged on line 2, and then list it again on Line 10a to reduce the basis in your property.  However, only list it on 10a to the extent the basis (generally, the purchase price) of the non-depreciable property that you retain after discharge exceeds the debt remaining after your discharge (which includes both existing mortgages and loans secured by property you still own and any non-dischargeable debt).  This reduction in basis can result in capital gains tax liability in later years, but because of the residential capital gains exclusion, for most people it has no effect.

This “reduction in attributes” can be more complicated for business debt: for that, you should to consult your tax advisor.

Why is it that these forms are issued?  The idea that cancellation of indebtedness is income is pretty simple, and is designed to avoid what could otherwise be a great way to defraud the IRS: instead of getting paid money that would be income, you could “borrow” the money (because a loan is not income), and then have the “lender” just write off the “loan”.  To avoid this scam, the tax law generally treats cancellation of debt as income.

To avoid creating phantom income when there is no scam, but legitimate debt cancellation for non-fraudulent reasons, there are certain exceptions to the treatment of cancellation of indebtedness as income.  The most important for consumers are (a) discharge in bankruptcy; (b) insolvency; and (c) qualified principal residence indebtedness.

• Debt discharged in bankruptcy is simply not income for cancellation of indebtedness purposes.

• Debt cancelled to the extent of a taxpayer’s insolvency is not treated as taxable income.   Generally speaking, this means that if all of your liabilities exceed the fair value of all of your assets (including exempt assets and retirement plans), cancellation of indebtedness up to the amount by which you are insolvent is not taxable (once rendered solvent, the balance would be taxable).

• Finally, through the end of 2012, cancellation of secured loans used to buy, build or substantially improve your principal residence, or to refinance loans incurred for those purposes, is not taxable.

Even though cancellation of indebtedness may not be taxable, the law in many cases requires, or permits, creditors to issue Form 1099-C to report that cancellation to the IRS.  The IRS regulation (26 C.F.R. 1.6050p-1(a)(3)) states “Except as otherwise provided in this section, discharged indebtedness must be reported regardless of whether the debtor is subject to tax on the discharged debt under sections 61 and 108 or otherwise by applicable law.”  In other words, the fact that you get a 1099-C from a creditor does not mean that you owe tax on the money shown on the form.   That is the reason for the Form 982.

There are exceptions to reporting.  In particular, where a debt is discharged in bankruptcy, the IRS does not require issuance of a 1099-C unless it was incurred for business or investment purposes.   Cancellation or discharge of consumer debt in bankruptcy need not be reported on a 1099-C.   But it can be.

A few words of caution: if the debt, or part of it, was cancelled before you filed bankruptcy (through debt settlement or negotiation, for example), the creditor must issue the 1099-C unless another exception applies.   And that debt is not included on Line 1a of Form 982, because it was not discharged in bankruptcy.   As a result, even if you later file bankruptcy, you may owe tax on that debt cancellation income unless you were insolvent at the time you settled it.  For that reason, it may make sense not to settle your debts but to just file bankruptcy and discharge them.  Before entering into a debt consolidation or settlement program, or settling claims asserted against you, it is important that you discuss the tax aspects of your situation with an experienced bankruptcy attorney.

7 Responses

  1. What if you filed your mortgage as UNSECURED as part of your Chap 7 Bankruptcy, can the creditor seek a deficiency judgment later or will there be tax consequences? So far, the bank did not appear at the creditor’s meeting. They also have not filed a motion to have stay lifted. Their deadline to file a claim is coming up soon. I’m in limbo and the BK attorney who helped me knows nuffin bout nuffin.

  2. “Independent action” — good advice. Just about the only procedural vehicle to contest the completed and contested foreclosure action now.

  3. Drew;

    Loans were not sold to Freddie Mac – as part of the TARP program. And, if Freddie was creditor — loan was securitized. But, Freddie sells non-performing loans to — you guessed it — debt buyers.

    Will not succeed with FOIA — or other agencies — will bounce you around. Look into independent action for fraud and fraud on the court.

    Most likely — you were never dealing with Wells Fargo — to begin with.

  4. Drew or anyone else, so what if Freddie or Fannie owns your note from the beginning and the servicer (holder) is filing on you? What is the difference in it being sold as part of TARP vs. already a part of Fannie/Freddie?

  5. Is this one of the reasons why so many of us continue to be in limbo?
    Are they waiting till after 2012 so they can come after us
    for deficiency?

  6. Drew- maybe the 1099-A proves that the affidavit from WF was false and a fraud on the court and that the judgment is voidable? Were you pro-se, or did you have an attorney?

  7. This is a very interesting post. We where battling in court with Wells for over 4 years on a foreclosure action. I researched and found that the loan had been securitized. When I presented the information to the court that the wrong party was present, Wells provided an affidavit the it was never securitized. After four years of battling we lost. They foreclosed and removed us from the house Feb 1st. Guess what!! We get a 1099-A from not Wells Fargo, it was from Freddie Mac. I tried to sent a freedom of information request to Freddie with no luck. They replied that it wasn’t in the “right form” I called the number a number that was on the form. I finally got someone who didn’t know the very litigious nature of the relationship. He told me. yes it had been sold to Freddie as part of the TARP bailout back in early 2008. If any one has a great letter to Freddie Mac to get results in writing from the FOIA please reply!!

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