Only forgiven PRINCIPAL is subject to a 1099-C upon settlement or non payment – NO tax if you were insolvent

I see more and more 1099s not only after settlements, but because lenders chose to stop collecting.

• If you settle accounts for less than the full balance, you might well get a 1099 from the creditor if the discount was for more than $600.
• Many original creditors are sending out 1099s when the SOL expired or after a few years of inactivity.

You MAY have to pay income tax on the amount of PRINCIPAL forgiven, but NOT on forgiven interest and fees.

Debt buyers rarely send 1099s because they don’t know how much of the balance is interest / fees and how much is principal.

If the amount is significant, make sure that

1) you weren’t insolvent
2) interest and fees are NOT included in the 1099.

Make sure that the credit reporting is accurate!

Check the 1099 and your records, details are explained below.

Here are some IRS references:

The Mortgage Forgiveness Debt Relief Act and Debt Cancellation (tax years 2007 through 2012)

The IRS guidelines for tax year 2012, Publication 4681

The IRS worksheet to determine whether you were insolvent just prior to the cancellation of debt.

And here are attorney Dan Edelman’s comments [please note that this commentary is from 2006, prior to the Mortgage Forgiveness Debt Relief Act]:

XVII. VIOLATIONS: AMOUNT OF INTEREST IN DEBT

The Internal Revenue Code treats cancellation of debt as income under specified circumstances. 26 U.S.C. �6050P; 26 C.F.R. �1.6050P. The owner of a debt who cancels it must file an informational form 1099-C if the amount cancelled exceeds $600. Generally, cancellation of debt is income unless (a) there is a bona fide dispute concerning the debtor’s obligation to pay, (b) the debtor is insolvent, (c) the debt is discharged in bankruptcy. The amount that might constitute income is only the principal amount. On a credit card debt this is the purchases and cash advances. The failure to collect interest, finance charges, penalties, and fees is not income and has no tax consequence. See Debt Buyers’ Ass’n v. Snow, 06-101, 2006 U.S.Dist. LEXIS 6527 (D.D.C., Jan. 30, 2006). Because of this, the portion of the debt that consists of “principal” as opposed to “interest” is material, and falsely stating the amounts should violate 15 U.S.C. 1692e. Debt buyers traditionally have not obtained the requisite information from the owner of the debt to make an accurate report. See Debt Buyer’ Ass’n v. Snow, 06-101, 2006 U.S.Dist. LEXIS 6527 (D.D.C., Jan. 30, 2006). They are obligated to do so if it is available.

Receiving a 1099 does NOT necessarily mean that the creditor will stop collecting and you can even be SUED for the debt!

That’s what makes it really confusing. There has been quite a bit of litigation and here are a few cases:

DEBT BUYERS’ASS’N. v. Snow is a DC opinion frequently cited in subsequent litigation. The Debt Buyers Association sued Secretary of the Teasury Snow, seeking an exemption to the IRS requirement to send 1099s as debt buyers usually do not have the required info (amount of interest and fees) to prepare the 1099s accurately. Snow explains the 2006 RULES very well.

Amtrust Bank v. Fossett is a 2009 Arizona appeals court opinion regarding a lender’s suit after it issued a 1099 and it contains references to other states’ rulings. “We hold that while issuance of a Form 1099-C may be prima facie evidence of cancellation of a debt, the lender may rebut that evidence by showing that when it issued the form it did not intend to forgive the obligation.”

In re Zilka, 407 BR 684 – Bankr. Court, WD Pennsylvania 2009 is a Pennsylvania opinion regarding bankruptcy disbursements after the debtor received a large settlement to a creditor who had sent 1099s. The court ruled that the 1099s did NOT mean that the lender actually canceled the debts because it merely complied with the IRS regulations.

The regulations require creditors to send the 1099s after certain events (such as no payments, no collection efforts, etc. for certain amounts of time).

Snow suggests that creditors can include a statement indicating that they will continue to collect with the 1099. If they don’t do that, they might violate the FDCPA (if subject to it) because consumers would assume that they no longer owe after a debt is canceled. Box 6 of the 1099 is IMPORTANT! (see below)

Many of the 1099s I have seen actually DID include interest.

Some creditors used the balance around the time when the last payment was made and they didn’t include the fees and interest after that point. HOWEVER, they included previous interest and fees, which was added to the balance often for years and then also accrued interest. I’m not aware of litigation over interest and fees prior to the last payment and it may be worth a challenge if either the amount is significant OR you’re looking to get deletion of the entire account due to continued reporting of a past due balance.

According to some appeals court rulings, if a creditor gets paid AFTER they sent the 1099, they may just have to issue a CORRECTED 1099 with the correct amount canceled, such as $0. It appears that the courts ignore the WORK involved for consumers who actually paid tax on the amount forgiven and they then have to amend their tax returns (state and federal), which may require that they pay an accountant.

Credit reporting

Capital One in 2013: I have seen Capital One deduct the amount canceled from the total reported. They continued to report the INTEREST portion of the debt.

FIA (Bank of America) 2013: I’ve seen an account reported with the full amount.

What can LEGALLY be reported probably depends on the CODE for field Box 6 on the 1099, the “Identifiable Event Code:”

A Bankruptcy
B Other judicial debt relief
C Statute of limitations or expiration of deficiency period
D Foreclosure election
E Debt relief from probate or similar proceeding
F By agreement
G Decision or policy to discontinue collection
H Expiration of nonpayment testing period
I Other actual discharge before identifiable event

A client just received a 1099 from Chase with code G:

“G Decision or policy to discontinue collection”

However, Chase still reports the full amount on the credit reports (along with totally bogus RECENT 120+ late payments) and we disputed. I argue that credit reporting IS an attempt to collect as the past due balance lowers your credit rating and it likely has to be PAID to get a mortgage.

However, Code H clearly means that they can continue to collect.

“H Expiration of nonpayment testing period”

The creditor merely complied with the IRS rule.

Summary

1099s for canceled debts are a very complex subject and may result in consumer claims against creditors due to incorrect amounts, codes and credit reporting.

MANY consumers will NOT be liable for any tax as they are INSOLVENT.

Complete the IRS worksheet to determine whether you are insolvent:  IRS-Insolvency-p4681-opt.pdf

If you previously paid tax on a forgiven debt while you were insolvent, keep in mind that you may be able to AMEND your tax returns.