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How to Avoid Getting Taxed for Phantom Income and Debt Forgiveness

Written by Eva Rosenberg on June 22, 2011 in Tax  |   5 comments

How to Avoid Getting Taxed for Phantom Income and Debt Forgiveness By Eva Rosenberg, EA If you negotiate with a lender or credit card company to get your debt reduced, you walk away feeling lighter, happier, and calmer. Until the 1099-C arrives. Panic time! Not…

How to Avoid Getting Taxed for Phantom Income and Debt Forgiveness
By Eva Rosenberg, EA

If you negotiate with a lender or credit card company to get your debt reduced, you walk away feeling lighter, happier, and calmer.

Until the 1099-C arrives.

Panic time! Not only is cancelled debt taxable income, but it’s also generally taxed as ordinary income.

Except in cases when it’s not taxed at all:

1) Gift. When your loan is with a family member or friend, you may all agree to treat it as a gift. However, Wells Fargo, Chase, or Citibank is unlikely to gift you $25,000 or so just because you sit next to each other at Thanksgiving dinner.

2) Bankruptcy. If your debt was reduced or discharged at the same time as the 1.5 million nonbusiness bankruptcies in 2010 or 2011, there’s no income.

3) Insolvency. This is the exception most people overlook. If you’re insolvent the day before the lender waives your balance due, you can avoid paying tax on that 1099-C. The IRS considers you insolvent when your debts are higher than your assets.

4) Acquisition debt. For mortgages forgiven through 2012, the Mortgage Forgiveness Debt Relief Act of 2007 allows you to avoid paying tax on this particular debt cancellation. You are protected if the defaulted loan was the original debt on the property. Folks who refinanced and consolidated their debt, or pulled cash out of the new loan, are not protected. But you can try the insolvency route.

How to Convince the IRS You’re Insolvent

You can’t file this tax return electronically. You must provide an explanation. Include a worksheet showing your financial position before each lender cancelled a debt. List your assets (home, other property, used car, home furnishings, bank accounts, retirement accounts, etc.) in one column. List your debts in the next column. Include credit card debts, mortgages, personal loans (make sure you have them in writing), student loans, unpaid taxes, etc.

If the total of your asset column is higher than the total of your debt column, you’re not insolvent. You’ll owe the tax on all the 1099-C income.

However, if your debts are higher than your assets, you are insolvent up to the amount of the negative number. Suppose your cancelled debt is $15,000, and your insolvency computation results in $10,000 more debts than assets. You will pay tax on $5,000 worth of cancelled debts ($15,000 in debts, less the $10,000 insolvency). And if your debts are $20,000, then all of your cancelled debt will be tax-free.

Another Little Complication

That worksheet explains how you arrived at your insolvency computation. Next, use Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). The IRS insists you reduce any future tax benefits from the discharge to the extent that the discharged debt is not taxed.

The kinds of tax benefits you will reduce are things like passive loss carryovers, tax credit carryovers, capital loss carryovers, and contributions carryovers. If you have none of those, you may have to reduce the basis (tax cost) of any real estate you own.

Confused yet? Tax aspects of discharged debt get complicated, and it’s well worth consulting a tax professional. After all, if you’re going to avoid paying thousands of dollars in taxes on your loan forgiveness, don’t you want to also avoid potential tax problems?


Eva Rosenberg, EA, is the publisher of TaxMama.com®, where your tax questions are answered. She teaches tax professionals how to represent you when you have tax problems. She is the author of several books and e-books, including Small Business Taxes Made Easy. Follow her on Twitter: @TaxMama

The information contained in this blog post is designed to generally educate and inform visitors to the Equifax Finance Blog. The blog posts do not give, and should not be assumed to provide, personalized tax, investment, real estate, legal, retirement, credit, personal financial, or other professional advice. Before making any financial decision, you should always consult with the appropriate professionals who can explain your options, rights, and legal responsibilities, and advise you on any tax, legal, credit, or business implications that may result from those decisions. The views and opinions expressed by the authors of blog posts are their own views and may not be the views or opinions of Equifax, Inc. and/or its affiliates.


  1. Furious says:

    I would like to know if a lender can still file a 1099-c on a debt that is more than 10 years old. I have not heard from this lender in years then all of a sudden I get the tax form in the mail. Am I Legally obligated?

  2. Roseanne says:

    I ended up on disability due to a work related accident. My student loans were forgiven. They sent me a 1099. How can they expect me to pay this?

  3. Dave L. says:

    I have been in the Philippines since 2003. Before I left the States I paid all my balances and came to the Philippines. I had one credit card but paid that off.
    In 2015 I was doing research on places to rent because I planned to return to the States to get a divorce from my Philippine wife. I took advantage of a free credit search just to see what it said. I found that there was a credit report of an unpaid balance on my account which had been reported to the credit bureau. I called the credit card company and the lady said that my account had been closed in 2006 for none payment and the balance was written off. I did not know of any charges other than what I paid off. I immediately sent a letter to the card company and told them it was an honest error and that I would pay the balance just send me the paper work. I never heard back from them. I was never sent a notice of the cancel debt from any source.

    They apparently re-opened that suspended and written off account, charged me interest for the last ten years and wrote it off on their 2014 income tax which of course showed up on my IRS account as a cancel debt which I must figure as income on my 2014 tax return.
    This is a big crisis for me because I live on my social security benefit and a small $320 pension. The card company charged interest on that $800 balance and it turned into $24,041 that they took off their tax and advised IRS and I got the cancel debt.
    When I wrote the letter to them in 2015 they had my address yet I never received a notice of this action and did not find out about it until my 1040 was sent back by the IRS and the cancel debt revealed.
    I earn approx $15,000 on social security, and $320 in a small pension. I have no job here in the Philippines, investments, business or any other income. I have no medical insurance, medicare does not work here.
    This means my income goes from about $18,000 paying no taxes to $49,000 and owing the IRS about $12,000. It will take me likely the rest of my natural life to pay this off, that is if they let me make payments on it. I am 70 years old now.

    Is this right for a credit card company to do? It seems to me if they absorbed the $800 in 2005 that they would have had to take the $800 off their taxes as a loss in that year and not re-open the case ten years later or so adding interest to their advantage and taking off $24,000 in 2014 on their taxes.
    Any advice? Thanks, Dave

  4. Cheap Commercial auto insurance in Houston says:

    It is not mandatory but – I get asked this question all the time. I tell my insureds to buy it & here’s why: You have a contract with the rental car company & you have to abide by it, your insurance company does not. If you have collision & comprehensive on your personal auto policy, your insurance company will only pay actual cash value of the vehicle, less your deductible listed on your policy. The rental car company may want replacement value. Your company reserves the right to inspect the vehicle & if the rental car company just fixes the car immediately, your company can deny coverage based on this. Your company will not pay excessive labor rates. Your company will not pay administrative fees or excess towing charges. Your company will only pay loss of use if the rental car company can prove all the vehicles of that type were rented off their lot while the car was being repaired & the rental car company will want loss of use for the whole time. The rental car company may just charge your credit card for the damages & you have to contact your insurance company to try to collect. Then, if all works out & your company pays for the damages, if your company pays over a certain amount, it is a CHARGEABLE accident on your policy which could increase your rates (for 3 years usually) & if you have other claims on your policy, could result in nonrenewal. Is it worth the chance to be out all that money to save a few dollars when you rent the car???. Also, to have any coverage on your own policy for a rental, you MUST be the named insured, you cannot just be a listed driver.. Now, word of advice, DO NOT let ANYONE drive the car that is not listed on the rental agreement. ONLY the owner of the vehicle can give someone permission to drive & the owner is the rental car company. We recently had a rental car claim that was denied because the person that rented the car let someone else drive that was not on the contract. He has to pay the entire damages out of his pocket, collision, liability, everything.. Also, inspect the vehicle with a fine toothed comb with the rental car agent. Write down EVERY scratch, EVERY ding on the car & both of you sign this. I have seen rental car companies try to blame damage on one of my insureds that they are positive they didn’t do, so, this is in your best interest to be sure the car is in the same condition when you return it as when you got it. If everything is written down before you get the car, you have the proof.

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