When cancelled debt is treated as taxable income
An Iowa resident who receives forgiveness for part or all of one or more outstanding debts by a creditor might be surprised when a 1099-C federal tax form arrives. It may be a relief to be rid of the outstanding debts, but forgiven debt can be considered as income. This is because credit card debt involves an obligation to repay. Removal of this obligation is viewed as a form of income.
There are some situations in which cancelled debt might not be considered as personal income. For example, an individual's insolvency at the time of a cancelled debt could result in that amount not being taxed. Insolvency occurs if an individual's debts exceed the fair market value of assets. Bankruptcy is another scenario in which cancelled or discharged debts are not counted as income.
An individual who is dealing with a challenging financial situation might think that seeking a settlement directly with a creditor would provide the most effective method of getting a fresh start. However, it may be beneficial to consider both debt negotiation and bankruptcy if a large amount of debt is owed. If the tax implications associated with unsecured debt being forgiven are too great, it might be a better choice to file bankruptcy.
Legal assistance may be helpful in evaluating the pros and cons of both bankruptcy and debt negotiation. As part of the bankruptcy process, credit counseling will be required, during which time various avenues could be explored for mitigating excessive debt. The long-term ramifications of both debt negotiation and bankruptcy may also be compared so that there is a clear understanding of how credit will be re-established after the action is taken.
Source: Monterey Herald, "Barry Dolowich, Tax Tips: Cancellation of debt income", Barry Dolowich, Feb. 17, 2015