Cancellation of Debt Income, Form 1099-C, & How it Relates to Bankruptcy

When a creditor gives up collecting on a debt that is in default status, the creditor may decide to charge-off that debt.  A charge-off occurs when a creditor attempts to get a tax break from the IRS.  The creditor must send the debtor an IRS form “1099-C Cancellation of Debt” to the debtor and the IRS.  While the creditor gets a tax break, the debtor must absorb the COD “income” to offset the creditor’s loss.  This phenomenon occurs because forgiveness of debt is generally treated as taxable income to the debtor.  See Internal Revenue Code Section 180(d)(1) & (e)(4).

As an aside, until 2007, mortgage debt foregiveness was also a COD issue until the enactment of the Mortgage Forgiveness Debt Relief Act of 2007.  The act now allows taxpayers to exclude the debt forgiven on their principal residence if the balance of their loan was less than $2 million dollars.

So what does this mean for the debtor?

The IRS will treat the cancellation of debt (aka “COD”) as income realized against the debtor. That means when the debtor files a tax return, that COD income must be included as well. This is assuming that the debtor is subject to filing a tax return or has enough total income to be taxed at all.

Is COD income avoidable?

Yes, there is a way to avoid realizing COD income for tax purposes when bankruptcy is involved.  The debt must be discharged in bankuptcy before it is charged off by a creditor.  See the Internal Revenue Code Section 108(a)(1)(A).  In fact, Form 1099-C states on its reverse side that “debts canceled in bankruptcy are not includible in your income.”

Keep in mind that unless the bankruptcy case is deeemed to be a “no-asset” chapter 7 case, a creditor could file a claim in the bankruptcy case to get paid some form of monetary distributions where there are assets a chapter 7 trustee can sell off in a bankrutpcy.   This may apply even if the creditor submitted a Form 1099-C before or after the bankruptcy case was filed.  See In re Stephen M. Zilka v. Bayer Employees Fed. Credit Union, 407 B.R. 684 (Bankr. W.D. Penn 2009).   This is example of why an exeperienced bankruptcy attorney must be consulted prior to filing.

A second exception exists where the debtor can prove insolvency at the time the debt was charged-off.  See the Internal Revenue Code Section 108(a)(1)(B).  Insolvency “means the excess of liabilities (aka debts)  over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge.”  See Internal Revenue Code Section 108(d)(3).