Many consumers are not aware that you can get your credit card debt canceled at all. However, those who do may be in for a surprise when the IRS responds to this action by declaring your canceled credit card debt as taxable income. Surprisingly enough, there’s a way to get out of this as well. View our video guide here, and dig into the article below for details:
The Credit Card Debt Cancellation Process
If you need this information, chances are that you have already followed this process or are planning to cancel credit card debt. In most scenarios, you have contacted the credit card company about your outstanding debt and offered to pay a settlement amount because you cannot pay the full amount. In many cases, credit card companies will accept this, because lawsuits are expensive. The unpaid debt is considered forgiven, but that’s not necessarily the end of the story.
The forgiven debt counts as taxable income according to the IRS. “In general, if you have cancellation of debt income because your debt is canceled, forgiven, or discharged for less than the amount you must pay, the amount of the canceled debt is taxable and you must report the canceled debt on your tax return for the year the cancellation occurs.” The creditor may then send you form 1099-C, Cancellation of Debt.
Cases Where a 1099-C Does Not Apply
Note that this only applies to cancelled debt. If there is any ongoing attempt to collect the debt, such as selling the debt to a third-party collection agency, the debt is not cancelled. This only applies in the scenario where you have made arrangements with the credit card company to forgive part or all of your debt.
Likewise, if you escaped debt via filing for title 11 bankruptcy, debts wiped out in the bankruptcy process will not be considered taxable income. Certain other debt categories, such as qualified farm indebtedness or qualified real property business debts, are also an exception.
Cancelled debt related to “qualified principal residence indebtedness” (debts using your own house as collateral) also don’t figure into a 1099-C.
Filing Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness)
If you are using a tax preparation service, you have to specifically ask for a Form 982. Otherwise the cancelled debt is considered part of your taxable income. In using Form 982 to reduce taxes owed from a discharge of credit card debt, you have to take into account that your outstanding debt exceeded the Fair Market Value of your assets at that time. Therefore, you are considered “insolvent,” which basically means that you can’t pay your debts and is the reason you’ve reached this point in the first place.
The line to check out is line 1B on Form 982. Use the worksheet to compute the state of your insolvency. This is not hard to figure out; simply take the FMV of everything you own, and subtract the total amount of all debts you owe (including the declared credit card debt, plus mortgages, student loans, bills, etc.). If you have a negative number, you are insolvent by that amount. Enter that amount on line 2.
If you need a worksheet to help calculate insolvency, see IRS publication 4681. Generally, as long as you have financial issues sufficient to negotiate a cancellation of debt in the first place, obviously you were likely insolvent at this time.
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