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What You Need to Know About Ditching Your Debt This Season

Dec. 1, 2022, 9:45 AM

I didn’t buy anything on Black Friday or Cyber Monday. Clearly, retailers and I have different views of the word “sale.” I appear, however, to be in the minority. A record 196.7 million Americans gobbled up online and in-person deals over Thanksgiving weekend—nearly 17 million than in 2021—spending an average of $325.44 on holiday-related purchases.

That spending happened despite concerns about the economy and mounting debt. Total household debt increased by $351 billion to $16.51 trillion in the third quarter of 2022. And while the largest chunk of that debt, home mortgages, climbed by $282 billion, more concerning is credit card debt: The 15% year-over-year increase in credit card balances is the largest in more than 20 years.

Borrowing isn’t necessarily a bad thing. Sometimes, you just don’t have liquidity on hand—there may have been a large bill you didn’t expect or a payment you planned on just didn’t come (the bane of small business owners everywhere). It can be that carrying a little bit of debt tides you over until you can right the ship. But what if you can’t? Not being able to repay what you’ve borrowed doesn’t just cause embarrassment and a dip in your credit score—it can land you in tax trouble.

Cancellation of Debt

When you can’t pay what you owe, your lender typically gives you several options. Obviously, they want you to pay up. But if you can’t pay the entire balance, most lenders would rather get something than take a chance on receiving nothing at all. In that case, they may agree to settle and allow you to pay a portion of what you owe to close the account. It may feel like a win, but that’s not the end. That amount that you don’t pay? It doesn’t simply disappear. It may show up again at tax time on Form 1099-C, Cancellation of Debt.

Form 1099-C

Form 1099-C is issued by certain creditors when a debt is discharged for less than the full amount you owe following an identifiable event, and the amount is $600 or more. Those creditors, as outlined in Section 6050P of the tax code, include financial institutions described in Section 581 or 591(a), credit unions, various government agencies, and any business focused on lending money, such as finance and credit card companies, on a regular and continuing basis.

For purposes of the form, a debt is any amount owed, including principal, interest, fees, penalties, administrative costs, and fines. The entire debt doesn’t have to be canceled—it can be part of the total amount you owe. And the canceled debt doesn’t have to be the result of a friendly negotiation. A default because you didn’t pay what you owed on time could be considered a cancellation of debt.

Form 1099-C is filed by the creditor in the year following the calendar year in which an identifiable event occurs. The identifiable event isn’t always a bright line—it’s determined by the creditor and may be the result of a negotiation or when the creditor believes you cannot or will not pay what you owe. It also can include a discharge in a Title 11 bankruptcy or an event that makes the debt unenforceable in a receivership, foreclosure, or similar legal proceeding.

The amount reported is the amount that has been forgiven, not the original amount owed. And here’s the kicker: That amount is considered taxable income unless you meet an exclusion or exemption. Of course, since this is tax, there are many of those.

Exceptions

Exceptions are those events that do not result in cancellation of debt income and, as a result, are not required to be reported. Those generally include:

  • Amounts you owed that were canceled as part of a gift or inheritance;
  • Certain qualified student loans that were canceled because you agreed to work for some time in a particular profession, such as loans that you don’t have to repay if you teach or practice medicine in specific areas;
  • Certain student loan discharges that happened after Dece. 31, 2020, and before Jan. 1, 2026, as part of pandemic relief;
  • Canceled debt that would be deductible if you, as a cash basis taxpayer, paid it—meaning that if you reported the income, you would have simultaneously deducted it, making it a wash; and
  • A qualified purchase price reduction given by the seller of property to the buyer.

Exclusions

Exclusions are those events that still would be considered cancellation of debt but are not includible in income. Those include:

  • Debt that was canceled as part of a Title 11 bankruptcy—that includes Chapters 7, 11, and 13;
  • Insolvency—when your liabilities exceed your assets—that occurred immediately before your debt was canceled;
  • Cancellation of qualified farm or qualified real property business indebtedness; and
  • If your canceled debt is qualified principal residence indebtedness—a mortgage you took to buy, build, or substantially improve your main home—entered into and evidenced in writing before Jan. 1, 2026.

These exclusions can be tricky. For example, if you qualify, you may need to reduce certain tax attributes such as certain credits, carryovers, losses, and basis by the amount that is excluded.

Quirks and Responsibilities

You still could receive Form 1099-C even if you qualify for an exception or exclusion. This is because the creditor may not know that you qualify—they are only responsible for reporting the discharge of debt, not investigating the reasons for it. If that happens, you may need to annotate your tax return with an explanation to avoid getting an adjustment letter from the IRS.

What if you didn’t get Form 1099-C but didn’t qualify for an exception or exclusion? You’re not off the hook; you still are required to report discharged debt in income, even if it is less than $600.

The Takeaway

It can be easy to pile on debt, but it may be challenging to get out from under it. Even then, you might not be back to where you started; there may be pesky tax consequences to consider. If you think you need a fresh start, do your homework before attempting to shed any debt. That’s true even if the plan includes filing for bankruptcy since not all debts may be dischargeable. Dealing with debt you can’t pay can be tricky, so I recommend consulting with a tax professional before taking action.

This is a regular column from Kelly Phillips Erb, the Taxgirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl or Mastodon at @taxgirl@c.im.

To contact the reporter on this story: Kelly Phillips Erb in Washington at kerb@bloombergindustry.com