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Steve Bucci, the Bankrate.com Debt AdviserReporting forgiven debt on your taxes

Dear Debt Adviser,
I got a letter in the mail about a "Cancellation of Debt Form 1099-C." I have settled in full on this account and have the letter to prove it. My question is, what does that form mean? Do I have to pay something else even though it is settled in full?
-- Angela

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Dear Angela,
Here's a riddle for you. When is a forgiven debt not a forgiven debt? When it's income! Form 1099-C is the form used by lenders to report a cancellation of certain debts $600 or greater to the Internal Revenue Service. The form reports the amount that was forgiven in your settlement. For instance, if you had a $5,000 debt and settled with the lender for $3,500, the difference of $1,500 is considered income to you and must be figured into your annual earnings to determine your tax liability.

I can't say whether you will owe additional taxes at tax time, because I don't know your tax situation, and certain types of debts are excluded -- such as debts as a result of participation in a VA benefit or home-loan program, medical care and pharmacy co-payments, debts which are in dispute and are written off, and some Katrina-related debts. See a tax pro or read the IRS instructions for details.

Just like your annual W-2 wage and tax statement, 1099 forms are sent to both the taxpayer and the IRS. If you fail to include the 1099-C amount on your tax return, you may open the door to an IRS audit, something most of us try to avoid.

The IRS looks upon a settlement, or a cancellation of debt in their terms, as a "gift." Talk about gifts with strings attached! The same thing happens to people who win cars in store and media promotions. While it's really cool to have a new car to drive, reality hits when they have to report $20,000 (or more) additional income with no withholding to cushion the tax liability.

There are a number of reasons why I generally advise against settling a debt. They include that I believe in paying what is owed, even when it may be difficult to do so, and that settling a debt nearly always causes a negative mark on your credit. But as your letter demonstrates, there can be additional financial ramifications to consider when a debt is settled for less than what is owed.

My advice to you now is to get an opinion from your tax preparer about your specific situation and the specific debt involved. This is not as simple as it may seem; for example, some creditors mistakenly send 1099-C forms for charged-off rather than discharged debts. A charge-off removes a debt from a lender's books, but it does not forgive (discharge) a debt. The former cannot create a taxable event; the latter may.

I would also suggest that you double-check the reported amount on the 1099-C against your settlement letter to be sure that the amount is correct. If the amounts don't match, you will need to contact the creditor in writing and dispute the amount.

If you do owe additional taxes, look for budget cuts you can make to come up with the amount due by April 17. Some areas to consider cutting back on are eating out, dry cleaning, and telephone or Internet premium services. If you are facing a steep bill, a temporary second job may be in your future. Don't delay: Any tax you owe as a result of the debt settlement is due on the mid-April tax deadline. Even if you file for an extension, that only allows you to file the paperwork later. The IRS starts charging interest and penalties if you procrastinate.

Good luck.

The Debt Adviser, Steve Bucci, is the president of Money Management International Financial Education Foundation and the author of Credit Repair Kit for Dummies. Visit MMI for additional debt advice or to ask a question of the Debt Adviser go to the "Ask the Experts" page to ask a debt question.

Bankrate.com's corrections policy -- Posted: March 3, 2006
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