My 1099-Misc Contains Taxable and Nontaxable Income, How to Handle?

[NateW]

I received a 1099-Misc that includes taxable and nontaxable income in Box 3 (other income). No other income is shown. When filing my taxes, how do I report/include only the taxable portion of this income, knowing the IRS is receiving a copy of my 1099-Misc?

Here is the history behind this unexpected payment I received. When I divorced in 2001 my ex wished to remain in the marital home because of her 2 young children (from her previous marriage) and I agreed, but she was $25,000 short of the amount needed to buy me out of my half of the home's equity, so I loaned her the $25,000. The attorney I retained to draft the Property Separation Agreement recorded in the county land records a $25,000 lien on the house, with me being to note holder. The separation agreement contained the terms of the loan, which basically said 6% interest compound annually, interest and principal due in 15 years (a balloon payment).

Four years later my ex wished to do a cash-out refinance on the home and the only way the lender would approve her loan, because I was a lienholder, was if I signed a subordinate agreement, where the lender would be first in line to be paid from the proceeds from the sale of the house if she defaulted. I signed the subordinate agreement and in exchange, received $10,000 out of her refinance cash out proceeds as partial repayment (I did this because I thought I would never receive another payment from her, given her track record). I mailed my ex a receipt noting the amounts of the $10,000 applied to principal (about $2000) and interest.

I was correct in my thinking, I never received another penny from her. Sometime in 2018 I discovered her home went into foreclosure. Also around that time my ex contacted me and said I would get paid because a buyer was found, but that deal fell through because the potential buyer could not get her out of the house!

Several people I checked with who seemed to know about foreclosures and lienholders said I would never be paid and that my lien dissolves upon foreclosure.

Then last year, just before my mail forwarding order expired, I received a letter addressed to my old address from an attorney asking me to provide copies of my driver's license and SS card and a payoff statement for the lien on the house. I called the law office, after verifying it was a law office and the phone number was in fact, theirs. When I called I told them the payoff amount and asked how much I would get. "All of it," I was told. Payoff was about $40,000, with about $23,000 covering principal and the rest interest.

So how do I convince the IRS I only received $17,000 in interest income from the law firm? I think the law firm completed the 1099-Misc corectly-- they did pay me $40,000, and no categories on the 1099 cover the type of payment. There are no boxes for non-taxable amounts.

It's very important that I report this correctly because, although it's bad enough paying taxes on money that was mine to begin with, I received an approximately $17,000 credit through the Affordable Care Act that I will have to repay if the IRS considers the full $40,000 as income. I do have at least $23,000 leeway before I hit the credit cliff/income limit.

Thanks.

 

[Montecfo]

Include the $40k on your tax return. Create a negative offsetting entry for the amount of principal included, described as something like "loan principal included in above payment" leaving the proper net amount taxable.

Thus the 1099 is matched to the return, the appropriate amount taxed and reason made clear.

 

[SecondCor521]

I'm not sure I agree with the notion that they should have sent you a Form 1099-MISC. The law firm clearly knows that it's a lien payoff. (If you paid off a $40K balance on your mortgage, would you send your mortgage company a 1099-MISC? Probably not.)

To me what you're describing sounds like seller financed mortgage interest, which would normally have the $17K be reported on Schedule B as ordinary interest. That's how I would have suggested you report the $8K of interest income in 2005. Take a look at the instructions for Schedule B and search for seller financed mortgages. https://www.irs.gov/pub/irs-prior/i1040sb--2020.pdf

I'm not sure how you handle the situation where you received a Form 1099-MISC. A quick google says to contact the issuer and ask them to correct it. I think I would try to get the law firm issue me a corrected Form 1099-MISC with a zero in box 3. Or, if you call them quickly enough, maybe they haven't sent it to the IRS yet and can simply avoid doing so.

 

[cathy63]

I wonder if the lawyers think you previously wrote it off as bad debt since it's so long overdue? If you did, then the entire amount is taxable now, so that might be why they sent a 1099-MISC. They should correct it if you ask, but if they won't, then I'd enter only the interest on Sched 1 and attach an explanation and copy of the payoff statement. You'll have to file on paper instead of electronically, and the IRS might still ask questions.

 

[NateW]

Thank you Montecfo, SecondCor521, and Cathy63. Let's see what others say. This appears to be complex.

I never took a deduction for a bad debt on this. In 2005 when I received $10,000 from my ex's refinance company, I don't think I received a 1099 for that and may not have included any of that payment as interest income (which was $8000) when filing my taxes. If that is the case, in all fairness for my 2020 filing, I think I should include $25,000 as interest income (instead of $17,000), but my payoff statement notes $17,000 is interest. Does the IRS even care if I did or did not report the $8000 interest income in 2005? Not trying to not pay taxes due, just wondering if I'm opening a can of worms, so to say, by going back to 2005. I'll see if I have my 2005 tax return.

 

[SecondCor521]

It's way too late to amend your 2005 return.

They care, because they probably missed out on income taxes on that $8,000 of interest. But since you filed a 2005 return, the time limit has run out for them to audit you or assess penalties. So I don't think they can come after you for that.

I think you legally can just report the $17K in interest this year on schedule B if you want to. If your conscience demands, you could report the higher $25K amount and I doubt the IRS would have a problem with that.

 

[pb4uski]

I wonder if the lawyers think you previously wrote it off as bad debt since it's so long overdue? If you did, then the entire amount is taxable now, so that might be why they sent a 1099-MISC. They should correct it if you ask, but if they won't, then I'd enter only the interest on Sched 1 and attach an explanation and copy of the payoff statement. You'll have to file on paper instead of electronically, and the IRS might still ask questions.

^^^ This. Call the law firm and ask why they issued you a 1099-MISC rather than a 1099-INT. I presume that they have the payoff statement that you requested showed a total payoff of $40,000 with $23,000 of principal and $17,000 of interest.

I would think that a 1099-INT for $17,000 would be most appropriate, or a 1099-MISC for $17,000 would be acceptable.

If they refuse to issue a revised 1099, unless they give you a good reason that they shouldn't, then report $17,000 in Box 3. It is highly likely that you will receive a letter from the IRS because your return will not match with the 1099... and then you have to write back to them and explain the situation and probably provide a copy of the payoff statement, calculations, relevant documents, etc.

I liked Montecfo's proposed solution but I just can't figure out where in TurboTax you could enter the $23,000 reduction for the principal portion of the $40,000.

 

[38Chevy454]

I agree with pb4uski, can you ask the law firm to send a corrected 1099-MISC that lists the correct $17,000 in box 3? I think technically the form should be a 1099-INT, but at least if you get a corrected 1099-MISC it solves your problem of the excess $23,000 of income that is currently on the as-received 1099-MISC.



Otherwise your option is as Montecfo suggested and you can subtract out $23,000 from the $40,000. Just ensure some documentation to support it, which you have.

 

[NateW]

Thank you 38Chevy454 and Pb4uski. I will follow you're suggestions. Just to be clear, the law firm did not issue the payoff statement, I did and emailed it to the law firm and it is simply a Word document showing my calculations and the web link to the amortization table I used. It broke out what amount was principal and what was interest. I also included a scan of the receipt I mailed my ex in 2005 and it showed what was applied towards principal and what part of the $10k was interest.

I did phone the law firm a second time and requested that any 1099 I received show the interest income. They basically said 1099s were issued by their accounting dept. at headquarters in Chicago and they would pass this along to them. So I suspect it will be difficult for me to track down the correct person to speak to, but I will try and I'll ask for a 1099-INT.

Thanks for the tip about Turbotax. That is what I planned to use, but will file manually if I cannot get corrected 1099.

 

[Montecfo]

^^^ This. Call the law firm and ask why they issued you a 1099-MISC rather than a 1099-INT. I presume that they have the payoff statement that you requested showed a total payoff of $40,000 with $23,000 of principal and $17,000 of interest.

I would think that a 1099-INT for $17,000 would be most appropriate, or a 1099-MISC for $17,000 would be acceptable.

If they refuse to issue a revised 1099, unless they give you a good reason that they shouldn't, then report $17,000 in Box 3. It is highly likely that you will receive a letter from the IRS because your return will not match with the 1099... and then you have to write back to them and explain the situation and probably provide a copy of the payoff statement, calculations, relevant documents, etc.

I liked Montecfo's proposed solution but I just can't figure out where in TurboTax you could enter the $23,000 reduction for the principal portion of the $40,000.

I've done it in the past in TT. If I get into TT later I will describe it further.

I would definitely document it in the return, not wait for IRS notice (which could result in other scrutiny).

I'm a bit dubious the law firm will change the 1099. They would need independent 3rd party info which it sounds like they do not have. So from their perspective, the 1099 is not incorrect. But you know the answer if you do not ask.

 

[pb4uski]

I can see your point, but at the same time, the law firm issued the OP a check for $43k based on a payoff statement provided by the lender (the OP) that indicated $23k of principal and $17k of interest. Presumably they did some due diligence in reviewing the payoff statement and other relevant documents before writing a check for $43k so they know how much was income. If the OP had just made up a payoff of $100k rather than $43k would the law firm had just written the OP a check for $100k? I doubt it.

Now perhaps the law firm doesn't know how much if any that the lender might have written off and taken a loss for so they are reporting what they paid and it is up to the taxpayer to determine how much of that is income and how much is not income and justify it to the IRS.

 

[SecondCor521]

I still think it's weird that they're issuing a 1099-MISC in the first place.

Mortgages get paid off all the time via refinances. I don't see Rocket Mortgage or Quicken Loans or any title company issuing a bunch of 1099-MISCs when they pay off those other loans, and I don't think anyone is arguing that they should. Although the OP is dealing with a divorce situation I think it's still a mortgage as far as the IRS is concerned.

Even if OP had cancelled debt, that's not on the law firm to figure out. It's up to the OP to issue a 1099-C to their ex-spouse.

I still think the law firm is doing a poor job of trying to act like a title company. I'm guessing either someone doesn't understand or doesn't care that they issued a 1099-MISC when they probably shouldn't have.

 

[Montecfo]

Well we are all just guessing.

OP is not a mortgage lender. There were no loan terms to examine, just a recorded lien. The principal on the payoff differed from the amount of the lien. So maybe by policy they use 1099-Misc in those circumstances.

Recorded liens on real property by individuals are usually mechanic's liens which go into 1099-Misc stack. So maybe that is what happened.

And perhaps they just made a mistake. I am just guessing that it got reported as it did due to process. The transaction may not be unusual but it is also not typical.

 

[NateW]

I called the law firm this morning and spoke with the accounting department and was asked to email my request for a corrected 1099 with supporting documentation, which would be forwarded to the head office in Chicago. I just did that and oddly, the person I spoke to on the phone, her email address was in my contacts. So I went through my emails and sure enough, last year the staff person I was working with forwarded my email asking that only interest income appear on any 1099 I receive was forwarded to this person in accounting. Here is the reply I got from the staff person last June:

"I asked our accounting department and she said that you will receive a 1099 but she said that she didn’t think it is interest income. She said the reportable amount will be the amount of the check we issued to you."

I recall that email, and at the time replied that I was sure about half was interest and the other half nontaxable principal, per my payoff request, but decided to not press the matter and wait and see what showed up on the 1099 I got.

I just received confirmation from the accounting person (the one who said I would receive a 1099 for the full amount) that she got today's email from me and she said she forwarded my 1099 correction request to headquarters. We'll, at least I now have emails that I can show the IRS that indicate I tried to get this resolved in case the law firm won't correct my 1099.

I do appreciate the input I received from all the ERs that replied; very helpful! Thanks again.