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When I defaulted on my loan payments, the lender issued a Form 1099-C which makes it look like I was paid income – what’s that all about?

Thanks in large part to a wrongly-decided Depression-era U.S. Supreme Court case, if you borrow money and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes. The theory is that the portion of the loan you will no longer be required to pay back is a "windfall" reportable as income. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt. There are some exceptions to treatment of the discharged indebtedness as income, which include: (1) qualified principal residence indebtedness, an exception created by the Mortgage Debt Relief Act of 2007 and applicable to most homeowners, provided Congress keeps renewing the law when it expires; (2) debts discharged through bankruptcy; and (3) you were legally "insolvent" when the debt is cancelled, that is, your total debts are more than the fair market value of your total assets. A non-recourse loan is another exception, but this is rare among consumer debts. A non-recourse loan is a loan for which the borrower assumes no personal liability and the lender’s only remedy in case of default is to seize the property being financed or used as collateral. It is important to remember that, even if the forgiven debt is excluded from income, the amount of debt forgiven must be reported on Form 982, which becomes part of your federal income tax return. The reported income is ultimately "zero’d out" during the return preparation process.

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