Anyone who has settled a debt that was owed to a creditor, such as a credit card company, by payment of less that the total amount owed should be aware that the IRS could consider the difference to be taxable income. For example, if a credit card debt balance is $10,000, but the debtor negotiates that down to $6,000 or 60 percent of the balance, they would have $4,000 forgiven debt income, which must be reported as other income on Line 21 of their 1040 tax form.
Taxpayers in that situation may have to fill out 1099-C. This is a forgiveness of debt form, and failure to complete the form may result in fees and penalties if the additional tax in a timely manner.
When any creditor or debt collector accepts an amount of at least $600 less than the original account balance, the law requires them to file a form 1099-C with the IRS and send a copy of that form to the debtor. According to tax preparers, the surprise element of receiving the 1099-C could be eliminated if creditors advise debtors that a settlement could increase their taxable income.
Cancellation of debt forms filed with the IRS by debt collectors and creditors have increased over the last ten years. However, there are some exceptions to the rule, so taxpayers could benefit from consulting an attorney to help them determine if their individual cancellation of debt case could qualify as exempt. An attorney could also help a debtor who is in financial trouble with filing bankruptcy if the debt becomes unmanageable.
Source: CreditCards.com, "1099-C surprise: IRS tax follows canceled debt", Connie Prater, November 09, 2014