In January and February of every new year, I get numerous emails from people who have settled unsecured debts during the prior calendar year. They are surprised to find 1099-C forms in their mailboxes, which report to the IRS the forgiven debt balances as ordinary income. Many consumers are totally shocked to find they might owe taxes on cancelled debt balances. “How can I owe tax on a debt?” they want to know. “Can this be true? Is there anything I can do about it?” I figured I would write about this subject now, so I can point to this post when the email queries start hitting in January.

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At first glance, it really doesn’t make much sense. How can a debt be treated as income? The logic is that the consumer enjoyed the goods and services purchased on credit. So when the lender has to record a loss on part of the balance, the IRS takes the position that this is equivalent to income to the consumer. You got a bunch of stuff, essentially for free, goes the argument, so therefore you need to pay taxes on that “gift.”

Under the current IRS code, that’s just the way it is, and there’s little point in wishing it were otherwise. Fortunately, there is a loophole provided by the IRS in the form of the insolvency exclusion. “Insolvent” means the same thing as negative net worth, where you owe more in debts than you own in the value of your assets. If you are insolvent at the time you reach a settlement with a creditor, then you can offset the 1099-C income up to the total amount by which you were insolvent.

Here’s an example to make it more clear. Let’s say you settled $50,000 of debt during 2009, and you paid an average of 50 cents on the dollar, resulting in a savings of $25,000. Will you have to pay taxes on the savings of $25,000? That depends on your net worth situation. Let’s assume that your home equity was flat or upside down (very common nowadays), so you don’t have any positive asset in the form of home equity. To keep it simple, we’ll ignore personal effects and automobiles. Your assets at time of settlement were limited to $20,000 in a 401k account (yes, retirement funds count in the asset column), plus $1,000 in checking, for a total of $21,000. You had $50,000 in unsecured debt. Therefore your net worth was negative $29,000 ($21,000 of assets, less $50,000 of debt).

Come January, you receive 1099-C forms from the creditors you settled with, and the total of those forms adds to $25,000 – the amount of debt that was forgiven. Since you are “insolvent” by $29,000, you can exclude the full $25,000 saved during the negotiation. In this situation, no extra tax liability would result from the 1099-Cs issued for the settlements, and the insolvency exemption has come to the rescue.

[UPDATE December 2013 — NEW Insolvency Calculator now available! Only $29 to save countless hours of frustration! Instant download. Read more …]

What would happen if you did have home equity? Let’s say that you had $30,000 of home equity based on the fair market value of your property, and all the other figures quoted above also held true. In that situation, your net worth would be positive. The $30,000 of equity added to the $21,000 of 401k and cash yields total assets of $51,000, against $50,000 of debt, for a positive net worth of $1,000. Under these circumstances, you would be liable for taxes on the full $25,000 of 1099-C income associated with the canceled debts. :-(

It’s also possible that you might overlap these two scenarios, where you get to exclude some of the 1099-C income but not all of it. For example, let’s adjust the equity value in the above scenario from $30,000 down to $10,000, giving you $10k equity + $21k other assets, for a total asset value of $31k. Against $50k of debts, this results in a negative net worth of $19,000. Yet with $25,000 of debt forgiven, only $19k of this figure could be excluded, and the remaining $6,000 would have to be treated as ordinary income.

The above seems pretty simple when laid out like this, but for some reason, this entire discussion on insolvency still seems to throw many people a curveball. I see a lot of confusion on how to calculate net worth, and one of the biggest misunderstandings pertains to income. Sometimes people ask, “I’m working and my job is stable, so how can I declare insolvency?” Income has nothing to do with your net worth, so let’s at least try to clear up this key point. Income & expenses are one accounting category, while assets & liabilities (debts) are another category. It’s possible to be insolvent while you still make a six-figure income! Income is not an asset, until it becomes excess cash in your bank account, after expenses. So just because you have a job with a steady paycheck, that does not block you from claiming the insolvency exemption via Form 982. You can still owe more in debt than you own in assets even if you are working steadily.

Another stumbling block is when to perform the net-worth calculation. Technically, the IRS says you must calculate net worth at the time of settlement. OK, but what is the time of settlement? Is it the date the creditor verbally agrees to settle? Or is it the date their accounting department actually makes the ledger entry to write off the forgiven part of balance – and how could we ever know that date anyway? Pending any possible adjustments or improvements to the clarity of the IRS language on this subject, my standing advice to clients is that they should perform one net worth calculation for each settlement. For “time of settlement,” we use the date the settlement payment is due rather than the date of the agreement letter itself. If the settlement is a multi-payment arrangement, then we take the date of the final payment as the date of settlement. In the absence of any clear directive on this point from the IRS, the above would seem to be the most logical interpretation.

I strongly urge consumers to get professional help to assist with the tax issues associated with settlement, but I wanted to at least get across the fundamentals. Mainly, consumers really need to understand that the insolvency exemption is available, especially since debt collectors often try to talk people out of settlements by scaring them on the tax issue. In my experience, the majority of people pursuing debt settlement are insolvent and do qualify for the exemption. However, I also feel that it would be very foolish to reject the debt settlement strategy just because it might result in a tax bill. After all, the total of the settlement payout + taxes would still be well under the full balance on the account, resulting in an overall net savings. And even when taxes are “part of the lunch,” settlement still yields a vastly better outcome than the “forever plan” (i.e., endless minimum payments) offered by your friendly credit card bank!

Don’t let the 1099-C tax issue scare you away from debt settlement. Just be sure to follow the rules and document everything correctly. Settle your debts, claim insolvency if you are entitled to, and pay your taxes if you aren’t! Whether or not you owe taxes on your settlements, you’ll still be vastly better off without the debts on your back.

UPDATE February 29, 2012:

Consumers are now receiving 1099-Cs from creditors for debts that are several years old, in some cases decades old. In response to new rules by the IRS, companies are sending out these forms, and consumers are seeing little guidance from the IRS on dealing with this confusing situation. If you have received a 1099-C on an old debt obligation, here is a link to an excellent article by Gerri Detweiler, who has thoroughly researched this issue.

[UPDATE December 2013 — NEW Insolvency Calculator now available! Only $29 to save countless hours of frustration! Instant download. Read more …]