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First we need to get the concept of creditor/debtor straight so we are speaking the same language and avoid confusion and misunderstanding.
A creditor is any party to whom money is owed. A debtor is the party owing the money. Thus, for example, if you borrow money from a bank to purchase an automobile the bank is the creditor and you are the debtor.
Form 1099C is issued by a creditor to a debtor when an obligation of the debtor to the creditor is canceled or forgiven. With certain exclusions being permitted by law, the debtor must reflect the cancellation of debt on his/her tax return. This is done on Federal form 1040, line 21 (of the debtor)and not on the debtor's Schedule C. The creditor does not recognize an income from this but does recognize a business loss to the extent of the amount of the obligation which is forgiven. Here is a bit of information on this from the IRS. You can read more about this at the IRS web site www.irs since there are specific rules pertaining to home mortgage forgiveness, business debt forgiveness and other forgiven debts.
Topic 431 - Canceled Debt - Is it Taxable or Not?
In general, if you are liable for a debt that is canceled, forgiven, or discharged, you must include the canceled amount in gross income unless you meet an exclusion or exception. However, canceled or forgiven debt is not considered income if it is intended as a gift or bequest.
A debt includes any indebtedness for which you are personally liable or for which you are liable only to the extent of the property securing the debt. Cancellation of all or part of a debt that is secured by property may occur because of a foreclosure, a repossession, a voluntary return of the property to the lender, abandonment of the property, or a principal residence loan modification. You must report any taxable amount of a debt that is canceled, as ordinary income from the cancellation of debt, on Form 1040 or Form 1040NR and associated sub-schedules, as advised in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals).
Caution: If your debt is secured by property and that property is taken by the lender in full or partial satisfaction of your debt, you will be treated as having sold that property and may have a reportable gain or loss. The gain or loss on such a deemed sale of your property is a separate issue from whether any canceled debt also associated with that same property is includable in gross income. See IRS Publication 544, Sales and Other Dispositions of Assets, for detailed information on reporting gain or loss from repossession, foreclosure or abandonment of property.
If a federal government agency or an applicable financial entity cancels or forgives a debt you owe of $600 or more, you should receive a Form 1099-C (PDF), Cancellation of Debt, showing amounts and other information relating to the cancellation. The amount of canceled debt is shown in Box 2 of the form. Taxpayers may also receive a Form 1099-A (PDF), Acquisition or Abandonment of Secured Property.
Canceled Debts that meet the requirements for any of the following exceptions or exclusions are not taxable.
Canceled Debt that Qualifies for Exception to Inclusion in Gross Income:
Canceled Debt that Qualifies for Exclusion from Gross Income:
The exclusion for "qualified principal residence indebtedness," provides canceled debt tax relief for many American home owners involved in the mortgage foreclosure crisis currently affecting much of the country. The exclusion allows taxpayers to exclude up to $2,000,000 ($1,000,000 if married filing separately) of "qualified principal residence indebtedness".
Generally, if you exclude canceled debt from income under one of the exclusions listed above, you must also reduce your tax attributes (certain credits, losses, and basis of assets) by the amount excluded. You must file Form 982 (PDF), Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to report the exclusion and the corresponding reduction of certain tax attributes.
Refer to Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals), for more detailed information regarding taxability of canceled debt, how to report it, and related exceptions and exclusions. Additional information can also be found in Publication 525, Taxable and Nontaxable Income.
The principal (and any interest that was previously reported as income but not received) is a bad debt. If this was a loan to/for business purposes it is a business bad debt. Otherwise it is a personal bad debt. Business bad debts can only be deducted on Schedule C if this is the nature of your business (making loans). Otherwise, both bad debt types must be claimed as itemized deductions.
Interest received on the loan would have been required to be reported on Schedule B (again, unless this is you business). Yes, you can issue a 1099C but unless your business is a financial institution the issuance is not required.
Here is a piece from the IRS on bad debts and their treatment. It will guide you in gathering the records to support the proper treatment of the bad debt.
Topic 453 - Bad Debt Deduction
If someone owes you money that you cannot collect, you may have a bad debt. For a discussion of what constitutes a valid debt, refer to Publication 550, Investment Income and Expenses, and Publication 535, Business Expense. To deduct a bad debt, you must have previously included the amount in your income or loaned out your cash. If you are a cash basis taxpayer, you may not take a bad debt deduction for money you expected to receive but did not (for example, for money owed to you for services performed, or rent) because that amount was never included in your income. For a bad debt, you must show that there was an intention at the time of the transaction to make a loan and not a gift. If you lend money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan.
There are two kinds of bad debts - business and nonbusiness.
Generally, a business bad debt is one that comes from operating your trade or business.
The following are examples of business bad debts (if previously included in income):
A business deducts its bad debts from gross income when figuring its taxable income. Business bad debts may be deducted in part or in full. You can claim a business bad debt using either the specific charge-off method or the nonaccrual-experience method.
All other bad debts are nonbusiness. Nonbusiness bad debts must be totally worthless to be deductible. You cannot deduct a partially worthless nonbusiness bad debt.
A debt becomes worthless when the surrounding facts and circumstances indicate there is no reasonable expectation of payment. To show that a debt is worthless, you must establish that you have taken reasonable steps to collect the debt. It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You may take the deduction only in the year the debt becomes worthless. You do not have to wait until a debt is due to determine whether it is worthless.
A nonbusiness bad debt is reported as a short-term capital loss in Part 1 on Form 1040, Schedule D (PDF). It is subject to the capital loss limitations. A nonbusiness bad debt deduction requires a separate detailed statement attached to your return.
For more information on nonbusiness bad debts, refer to Publication 550, Investment Income and Expenses. For more information on business bad debts, refer to Publication 535, Business Expenses.