Can you be taxed for debts discharged in bankruptcy and what to do if you received a 1099 issued to the IRS for debt?

Posted on Mar 03, 2014 By Ronald C. Sykstus

Attorney Ronald SykstusMany of our clients present us with these questions, especially during tax season. The simple answer to these questions is… maybe…

This area of questions is actually quite complicated.  If you find yourself presented with these types of questions, we recommend seeking the assistance of your tax advisor or a tax professional.

To give you an overview of this area, I will address these areas one issue at a time.

Settling a Debt For Less Than Owed

The first question is what happens if you settle a debt and pay the debt collector or creditor less than what you owe? Many times, debt collectors will try to coerce a settlement from someone claiming that the person owes money but that they will accept less than what is owed and that this will supposedly settle the debt in full. Please make sure that is the case if you try this tactic and obtain this agreement in writing.

Oftentimes, debt collectors and debt buyers will simply sell the difference of what you didn’t pay to another debt collector who will then tell you that the debt was not settled in full. Additionally, the first debt collector with whom you settled can issue a 1099 forgiveness of debt to the IRS and that difference will be taxable income to you. By way of example, let’s say a debt collector says you owe $10,000. You are not sure exactly what you owe or even what the debt is about. Many times, however, when people are harassed in this manner, they will want to put this perceived issue behind them. Let’s say the debt collector says pay us $5000 today and we will forgive 50% percent of the debt. You settle it that day and then the debt collector will submit to the IRS and copy you with a 1099 showing that you received $5000 in “income” for the forgiveness of debt. First of all, when you settle debts in this manner, make sure that you write on the memo section of the check “for full and complete satisfaction of all debts and accounts between John Doe  and ABC Debt Collector for XYZ creditor account #123…” (spell out your full name and the debt collector and  the underlying creditor, account number, etc,). This will give the debt collector some problems if and when the debt collector tries to sell the debt later on to another debt buyer. Additionally, there is a question as to whether a 1099 should issue for disputed debts.   Make it clear in writing also if you dispute a debt and settle it with “reservation of all rights.” At least that way, you have given your tax advisor a fighting chance as to whether this is really taxable income to you. The settlement of debts, however, is a very tricky area and you would be well advised discussing any strategy with an attorney and a tax advisor before you actually embark on this type of plan.

Taxed for Discharged Debts

The second issue is what if you get a 1099 for debt forgiveness and you file bankruptcy on that particular debt? The good news is that the IRS has already considered this matter and has issued a form to be submitted, IRS form 982, which deals with debts that were discharged in bankruptcy or where a person is insolvent. Please these links for the IRS form 982 and IRS Publication 908 on Debt Cancellation, Insolvency or Bankruptcy.  If you have filed bankruptcy and you receive a 1099 from various creditors and debt collectors that were listed and discharged in your bankruptcy, please use this form to address the 1099(s) you received and also bring it to your tax advisor or tax professional to address in the filing of your tax return.

1099 Issued for Short Sale of Home

Finally, what can a person do if he or she sold their principal residence as a short sale and the lender now issued a 1099 for the difference forgiven. Are taxes required to be paid on that difference?  The Mortgage Forgiveness Debt Relief Act was enacted to cover this situation through the end of tax year 2013, so that should allow someone in this circumstance to avoid being taxed in this circumstance. There was some talk in Congress about extending this law but, as of the date of this blog, it is not been extended. Please check with the IRS and  your tax advisor  if this issue applies to you. Of course, if you filed for bankruptcy and surrendered your home in bankruptcy, then the IRS form 982 debtor insolvency form addresses this issue for you.

This is just a general overview of these topics as, again, these questions come up repeatedly during tax season and can be quite complicated. With regard to debt settlements, please contact our office to talk to one of our consumer lawyers with regard to with regard to your personal financial situation. If you have specific questions that are limited to the taxable consequences for other debt forgiveness and the receipt of 1099s for debt, please contact your tax advisor or your tax professional or preparer.