When a commercial lender cancels or forgives a debt that you owe, in order to claim the loss as a tax deduction in its accounting books it will issue you an IRS Form 1099-C (cancellation of debt attributed as income). You may not receive a 1099C immediately at the time that a debt is canceled but may receive it a year or so later. You can be sure, though, that if your lender has canceled your debt, then you will receive a 1099C. Otherwise it would be losing a significant tax savings. Your lender must issue you a 1099C in order to claim the canceled debt as a deduction on its taxes.
A 1099C is frequently issued by a sold-out junior lienholder after a foreclosure or by a lender after a short sale. After a foreclosure, your lender will issue a 1099C without you having a say in the matter. If you are doing a short sale, you can try to negotiate with your lender to not issue you a 1099C, however many lenders will insist that they must issue a 1099C after a short sale. If you have received a 1099-C for canceled debt as income, you have options for dealing with taxes on canceled loans or other financial obligations.
You will generally owe a tax debt on any canceled or forgiven financial obligation. The canceled or forgiven obligation is treated as your income on which you will owe income tax. Generally, unless you can meet an exception to the rule, canceled debt will be treated as ordinary income for tax purposes. You will have to pay taxes on it just as if the canceled financial obligation was actual income that you earned during the calendar year in question.
There are various exceptions to 1099C tax liability. However, bankruptcy is the main exception to 1099C tax liability and the only one that truly works. From December 2007 to January 1, 2014 there was another viable exception called the Qualified Principal Residence Indebtedness Exception, discussed in detail in our after foreclosure page. That exception lasted only through January 1, 2014 and is no longer available, leaving bankruptcy as the only remaining viable option. When you file bankruptcy on taxes assessed in a Form 1099C. your tax liability reflected in a 1099C will be eliminated. There are other exceptions, such as insolvency, which do not work very well. Bankruptcy is the only exception that you can count on to eliminate the tax liability. For a full discussion of all exceptions, see the IRS Publication mentioned below.
A full discussion of how cancellation of debt is treated as income, the general rule, and exceptions to the rule can be found in IRS Publication 4681. This publication contains a detailed explanation of cancellation of loans, credit cards, and other financial obligations, as well as helpful examples.
As discussed above, bankruptcy is the last remaining feasible option for eliminating 1099-C tax liability for canceled or forgiven mortgage debt. The bankruptcy and tax laws concerning canceled debt are complex and a mastery of the law is required to ensure your case is handled smoothly. Always consult with an experienced bankruptcy lawyer regarding your potential tax liability and the effect that bankruptcy will have on eliminating it. Schedule a consultation with a lawyer who has specific experience handling matters involving discharge of tax assessed on canceled debt.