This year was the first year I claimed a debt as a source of income on my tax return, a canceled debt that is. For long time readers, you may remember that I was paying down a crummy line of credit – a line of credit that was charging me 29.99% interest! Obviously, I was not happy about this interest rate. I was able to make a deal with the original debtor and reduce my total amount due by $1,561 – a huge savings. The remaining portion I paid off or transferred to a 0% interest rate loan until the end of this year (so I’m still paying off a small portion of this debt using Dave Ramsey’s Debt Snowball method.)

However, I received a 1099 -C for that canceled debt. I ended up having to claim the canceled debt as income. Since the amount wasn’t huge, it didn’t affect my taxes in the long run. However, it got me thinking about how this might affect someone who is in the process of short-selling their home, for instance. Here is a description (line 21 on a 1040 if you’re interested) from the Federal Tax website:

Form 1099-C. If an applicable financial entity cancels or forgives a debt you owe of $600 or more, you will receive a Form 1099-C, Cancellation of Debt.

I researched this information a little more than normal because I personally know someone in the process of a short sale and wondered if they would have to claim a large portion as income once the sale goes through. There were many exclusions to this rule and it is a little bit confusing, if I do say so myself. Had I asked the creditor to grant me the decrease in principal as a gift, I might not have had to include this an income; complicated, but true.  With further research, I found that there is currently a moratorium on canceled debt when it comes to residential real estate:

The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. This provision applies to debt forgiven in calendar years 2007 through 2012.

I guess this will come as a relief to those short-selling their homes, as long as they can close the deals before Dec. 31, 2012.

Have you ever received a 1099-C? Have you had any debts canceled that fell into the exclusion category?

11 Comments

  1. Great info Little House!

    I’ve never received canceled debt, so I’ve never had such a form sent to me.

    Great find on the short sellers tax rule! I would have guess that they would have to pay extra on the debt that was canceled in the process. I guess houses are special…

    • @Money Reasons – I think they are just limiting the canceled debt on homes right now due to the housing bust. My guess is after 2012, the previous tax laws having to do with short sales/foreclosures will go back into effect – whatever those rules were.

  2. Hey Little House!

    I’m glad to see you posted about this. This is something that a lot of people aren’t aware of when they let their credit go. Also, good find on short sales.

    By the way, I just read your email and fished your blog comment out of the spam.

    Take Care, Mike

    • @Mike – Thanks for fishing me out of the spam file! Canceled debt is definitely something to think about – not only if you let your credit go, but if you negotiate a lower settlement! Then again, had I known the law before hand, I should have known to ask for the debt settlement amount to be recorded as a gift. 😉

  3. Lots of people are getting that nasty little surprise. They don’t pay the debt and it gets canceled and later on a 1099-c pops in the mailbox. It happened to a friend of mine and POOF there went her tax refund.

    • @Sandy – In my case, it’s not that I didn’t pay the debt, I settled the balance for a lower amount to save money on interest. I was just tired of paying so much on interest – in the end I got the better deal even if I did have to report it as income. 😉

  4. What a nasty shock, to have to get rid of your home on a short sale, and then get a tax bill for it, ouch.

    I know a real estate short sale damages your credit, what did the canceled debt do to your credit score?

    • @Ben – I don’t think the canceled debt did much to my husband’s score because we had paid the rest of the balance off in full per the creditors payment structure. This was also something we negotiated with the creditor on our own. But this is a good question. I’m sure that if it was something that had been settled in a bankruptcy filing, then it would definitely have effected his score, but in our case we simply complained to the creditor about the high interest rate and how we had paid so much over time we wanted a deal. However, in a short sale, this would definitely affect a credit score.

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