The IRS requires banks and financial institutions to report the cancellation of debts. This can happen when there is foreclosure, if there is a settlement on a consumer debt, or if the bank is simply unable to collect the debt within the time allowed by law. Bankruptcy can prevent tax liability but some creditors will report a cancelled debt even when a bankruptcy has been filed.
What do you do when you receive a 1099 stating that debt has been cancelled? It is best to report the debt cancellation on IRS Form 982. The form is complicated but most tax preparers know how to prepare it. Be sure to give them a copy of the 1099 so that they will know about the problem.
Do you have to pay tax if you get a 1099? The cancellation of debt may be reportable income on your tax return. However, there are several important exceptions. If the 1099 is generated by foreclosure of your personal residence; the Mortgage Forgiveness Debt Relief Act of 2007 may save you. Beware; the statute is limited in many ways.
Bankruptcy is the most important exception to tax on cancelled debt. If the debt was cancelled due to bankruptcy, you owe no tax. If the IRS sends you a notice claiming you owe tax because a 1099 was filed by a creditor, you must respond immediately. If you filed bankruptcy, send them a copy of your discharge notice with a short letter telling them the debt was discharged in bankruptcy. Follow-up with a telephone call to the number on the notice you received to make sure they got your letter within the time allowed.
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