What is forgiveness of debt income?
When you owe money and do not pay the full amount of the debt the lender is required to file a 1099 form with the IRS showing that you had phantom income in the amount the creditor forgave. This is referred to as ‘forgiveness of debt’.
Exceptions to forgiveness of debt:
Certain instances of “forgiveness of debt” cannot be taxed – typically bankruptcy is one of those exceptions. These exceptions are listed on IRS form 982, which you must fill out and file with your tax returns. Make sure to read and follow the directions when filling out the form.
Negotiating a settlement of debt vs bankruptcy
Negotiating a settlement of a debt will lead to tax obligations. Many of my clients tried to settle their own debts (either by hiring a company or doing it on their own), unfortunately no one warned them about the tax problems. These tax issues cannot be discharged in bankruptcy; at least for several years. Had my client filed bankruptcy to discharge the debt then, in most consumer cases, there are no tax consequences.
I filed bankruptcy then received 1099 Income Statement from a creditor.
When you receive a 1099 form after filing for bankruptcy then file the 982 form (discussed above). Mark the box that you filed bankruptcy and file the form with your tax returns. Keep a copy for your records.
Note – if the creditor forgave the debt prior to you filing for bankruptcy protection you may be faced with tax issues. But there might be another exception that protects you – check the ‘insolvency’ description on the 982 form to see if you qualify for that exception.