It's the one document from their lender that most people don't expect.
The form is the 1099-C. It is a single-page tax document sent by lenders or debt collectors, and because it looks nothing like the familiar W-2s sent by employers, many people assume it's junk mail.
But it is a critical piece of information for anyone who has had debt forgiven — credit cards, car loans, mortgages or student loans. And if ignored, it could land a taxpayer in big trouble with the federal government.
“It catches them all by surprise,” said George Siegel, a CPA and owner of Siegel & Company, an accounting firm in the South Side. “It's one of those forms they're not prepared for. Nobody tells them that they may possibly have to pay income taxes on discharged debt.”
Few people realize the tax consequences of having debt discharged. As the government sees it, when a lender forgives debt, it is essentially paying the debtor income. Any amount over $600 is taxable.
The issue affects many cash-strapped taxpayers who are least able to pay, said Shawn Wright, a tax attorney in Green Tree. After all, they are people who could not afford to pay their debts in the first place.
But they still may have options to avoid a severe financial hit.
“For many people, if they have the correct strategy, they can avoid having to pay taxes on any of it,” Wright said.
Just because someone receives a form 1099-C doesn't mean they have to pay taxes on the amount listed on the form. Not all canceled debt is subject to income tax.
Debts discharged in bankruptcy are exempt. Balances that have been forgiven on some types of student loans — e.g., federal or state loans — also cannot be counted as income.
Homeowners who have been through foreclosure or restructured the mortgage on their principal residence also get some relief.
A law passed during the housing crisis, called the Mortgage Debt Relief Act, excludes as income mortgage debt discharged up to $2 million. The law has been renewed several times since it was passed in 2007 and now extends through 2016.
But tax professionals say the most common type of debt discharged is on credit cards. Unfortunately, that is not among the exemptions.
Financially distressed taxpayers with credit card debt still have options, even if they are not bankrupt. Someone doesn't have to count discharged credit card debt as income if they lack the ability to pay it.
“You can be insolvent without being bankrupt,” said Joe Landolina, a tax attorney at the Downtown firm Love, Scherle & Bauer.
Insolvency means that someone owes more than the value of their assets. An insolvent person may not have to pay tax on any portion of a canceled debt, or maybe only a portion of it.
Here's a scenario from the Internal Revenue Service: Suppose “Greg” had $7,000 worth of assets — cash, a car, computer, furniture — and $15,000 of debt. He is insolvent by $8,000.
If Greg had $5,000 of his debt canceled — say, on a credit card — he would not have to pay income tax on it. Why? Because it is less than the amount by which he is insolvent. He therefore doesn't have to count the forgiven credit card debt as “income.”
However, suppose Greg had only $10,000 of debt, making him insolvent by $3,000. If he had that same credit card balance — $5,000 — canceled, then it would cover the amount by which he was insolvent, giving him $2,000 left over. That would be considered income. Therefore, he would have to pay taxes on it.
Information about canceled debts and exemptions can be found in Publication 4681 on the website IRS.gov.
Experts advise anyone who is confused to contact a tax professional. Spending a couple hundred dollars to hire an expert could save them a more expensive and time-consuming visit from the IRS, Siegel said.
Even if someone ends up paying thousands of dollars in tax on the canceled debt, they don't have to pay it all at once. The IRS usually is willing to work out a payment plan that could extend up to six years, Wright said.
“The problem that a lot of people have dealing with the IRS is they call and they can't get through to somebody,” Wright said. “Call early in the morning. You just have to be persistent. But it's not a difficult negotiation.”
Chris Fleisher is a Tribune-Review staff writer. Reach him at 412-320-7854.
