A few times a month we receive a phone call from someone that is very upset as they have just received a 1099 from one of their creditors for a debt that was forgiven or discharged in bankruptcy. They could not afford the payments anymore and thought the creditor had moved on, or they had taken care of the debt by filing bankruptcy. Now they are faced with a large tax bill. It’s just not fair and doesn’t seem right. How could this happen? Well, the good news is that you almost certainly will not have to realize the 1099 income on your tax returns.
The Internal Revenue Code contains specific provisions regarding the recognition of forgiven or discharged debt. The relevant code section is 26 U.S.C. § 108. This section explains that if you have filed bankruptcy, you will not include the discharged debt in your gross income. The section further explains that if you have not filed bankruptcy, you may still exclude this amount from income if you were insolvent at the time the case was filed. This simply means that if your liabilities exceed your assets, you will not have to recognize any forgiven debt as income. If you’ve reached the state where debts are being forgiven, it is unlikely that you are solvent.
This all seems pretty straight-forward, but you’d be surprised by how many “tax preparers” don’t know this. Wherever you live there is likely a national tax preparation chain around the corner. The majority of these “tax preparers” have no accounting background and are focused on getting you in and out as quickly as possible.
I recently had a client that had received a 1099 for forgiven debt and was concerned about the tax liability. He usually received a refund of about $1,500.00 and used that money to purchase necessities for his young son. His “tax preparer” told him that due to the 1099 he would owe the IRS about $1,000.00. The client explained that he didn’t believe this was correct and even provided the “tax preparer” with a copy of the relevant tax code. The preparer told him the exclusion didn’t apply and filed the return with the forgiven debt included as income.
When I met with the client I was able to recognize the error on his tax return. We were able to help the client file an amended tax return with the correct income information. The client no longer owed the IRS and was entitled to his normal refund.
If you have questions regarding a 1099 you have received from a creditor then call us today.