Forgiven Debt? Not entirely…

Have you negotiated the balance due on a credit card, car loan, or a bank loan to a lesser amount?  Have you had a short sale of your home?  Did you breathe a big sigh of relief thinking that you had alleviated the problem?  The IRS rules may not be so forgiving.  Read what Connie Prater has to say for some excellent advice on understanding what the tax implications may be.

1099-C surprise: IRS tax follows canceled debt

Forgiven credit card debt may be taxable income

By Connie Prater

If you thought your money woes ended last year when you settled that credit card debt, think again. For many consumers with debt problems, after the debt collector leaves their lives, the taxman arrives.

Months after successfully resolving credit card debts, consumers may receive 1099-C “cancellation of debt” tax notices in the mail. Why? The U.S. Internal Revenue Service considers forgiven or canceled debt as income. Creditors and debt collectors that agree to accept at least $600 less than the original balance are required by law to file 1099-C forms with the IRS and to send debtors notices as well. Taxpayers must report that portion of forgiven debt as “income” on their federal income tax returns.

“A lot of people don’t realize they have any tax issues at all when they are going through this,” says Alison Flores, a researcher at The Tax Institute at H&R Block, the nation’s largest tax preparation service. “They say ‘I’m really poor, I’m broke and I can’t pay my bills. How can you consider this income?'”

It is, according to the Internal Revenue Code. For example, a person with $10,000 in credit card debt who negotiates to pay only $6,000 of the balance would have $4,000 in forgiven debt income. That $4,000 must be reported as “other income” on Line 21 of the 1040 tax form. Depending on the amount of debt forgiven, the taxpayer’s income level, deductions and other factors, the consumer could face a sizable tax bill come mid-April.

Surprise tax problem

The problem: Many consumers have no clue what the 1099-C forms are, and some may be trashing the cancellation of debt notices because the forms are sent by creditors or debt collectors with whom they thought they no longer had business. Still others are not filing the 1099-Cs with their federal income tax returns — putting taxpayers at risk for IRS audits, penalties and fines. Consumer credit counselors and tax attorneys say few consumers are aware of the tax implications of settling to pay a lesser amount than they owe in credit card debt.

Just when they think the debt monkey is off their back, here comes the IRS obligation.

— Gail Cunningham

National Foundation for Credit Counseling

“It’s truly something that consumers need to be aware of, as they are often blindsided by it,” says Gail Cunningham, spokeswoman for the National Foundation for Credit Counseling, a nationwide group of nonprofit credit counseling agencies. “Just when they think the debt monkey is off their back, here comes the IRS obligation.”

The number of “surprise” tax problems grew as the amount of bad debt shot up during the recession, and has lingered since.

According to the IRS, the number of 1099-C cancellation of debt forms filed with the federal government by creditors and debt collectors saw a fivefold increase from 2003 to 2012 — the most recent year with firm figures (see chart). Most of the increase took place following the recession. The IRS received fewer than 1 million forms in the calendar year 2003 and 5.4 million in 2012. The projected number for 2014 is 6.5 million, and the IRS expects to get 8.3 million debt forgiveness forms in 2021.

Negotiating with creditors, debt collectors and debt buyers to pay a fraction of the amount owed is a common practice in the industry, often accomplished through third-party agents such as consumer credit counselors or debt settlement specialists.

“Debt buyers are willing to negotiate a discount, sometimes at a very significant discount off the entire balance, to settle the debt,” says Barbara Sinsley, general counsel for the 600-member Debt Buyers Association (DBA International), a trade group of companies that buy and sell portfolios of debt from banks and other creditors.

Not all forgiven debt taxable

Consumers who receive the 1099-C cancellation of debt forms should immediately take them to a tax preparer or tax adviser, experts say.

“Make sure your tax preparer understands the rules related to these type of activities,” says Mark Steber, chief tax officer for Jackson Hewitt tax preparation service. “Ask to talk to an office manager. Tell them ‘I need to see someone who understands this type of situation.'”

Taxpayers may qualify for one of several exclusions that allow them to reduce taxable income from canceled debts. If the exclusions apply, they must file an IRS form 982 in addition to the 1099-C.

“Theoretically, you have [taxable] income if you don’t meet one of the exceptions,” says Connecticut tax attorney Eric L. Green.

The exclusions include debts discharged during bankruptcy and debts of consumers who are insolvent (meaning their liabilities exceed their assets) prior to the cancellation of debt. However, the exclusion applies only up to the amount by which consumers are insolvent. That means if $5,000 in debts were forgiven and liabilities exceeded assets by $2,000, then the $2,000 would be not be counted as taxable income. “The remaining $3,000 would be reported under other income,” says H&R Block’s Flores.

Homeowners exclusion ends

Homeowners who default on mortgage loans on their primary residences may also qualify for an exclusion from income on foreclosures under the Mortgage Forgiveness Debt Relief Act, which took effect in 2007 to help homeowners caught in the mortgage crisis.

This provision applies to up to $2 million in mortgage debt forgiven in calendar years 2007 through 2013. Taxes filed by the April 2014 deadline were the last opportunity to claim the mortgage debt forgiveness exemption. This exception had been scheduled to expire at the end of 2012, but Congress extended it as part of the “fiscal cliff” negotiations.

Steven M. Piascik, a certified public accountant and president of Piascik & Associates in Richmond, Va., warns, “If you use the proceeds from a home equity line of credit to pay off credit card debts, or for something other than making improvements to your home, that portion will not qualify for the $2 million exception.”

However, if you used a credit card to pay for home improvements on your primary residence and can prove that the charges were exclusively for home improvements, you may be able to claim an exemption from mortgage-related debt forgiveness income for that card debt.

Informing consumers

Much of the surprise element of the 1099-C cancellation of debt forms could be eliminated, say tax preparers, if all creditors and debt buyers routinely informed consumers that there could be tax ramifications when settling debts for discounted amounts.

At Wells Fargo, one of the nation’s five largest credit card issuers, all settlement-offer letters include disclosure of possible 1099-C implications, according to Lisa B. Westermann, assistant vice president of public relations for Wells Fargo Card Services. Other credit card issuers did not respond to requests for information about their policies.

Be aware and prepare for it. When you receive that form, go immediately to a tax adviser. Don’t ignore it. That has real dollars and cents consequences.

— Eric L. Green

Tax attorney

“The bank doesn’t tell you,”  says Green, the Connecticut tax attorney. “From the bank’s perspective, it’s not their job to give tax advice.”

Says Sinsley from the debt buyers group: “There is no current law that says that a debt buyer must disclose that a 1099-C would be forthcoming after the settlement of debt.”

The National Taxpayer Advocate Service has cited confusion and inadequate communication about 1099-Cs in its annual report to Congress on IRS improvements needed to help consumers. The taxpayer advocate’s office has published YouTube videos in an effort to demystify the 982 tax forms needed to claim an exemption from taxes on forgiven debt.

Another potential problem: receiving a 1099-C before the debt is actually paid off. According to Lauren Saunders, managing attorney for the National Consumer Law Center, creditors have sent cancellation of debt forms to consumers at the point that the credit card issuers charged off the debt and sold it to debt buyers. “The consumer is potentially liable both for taxes on supposedly forgiven debt while continuing to be liable for the debt,” Saunders says. “We’ve had calls about that situation. Seems like you can’t have it both ways: Either you forgive it or sell it but not both.”

The federal taxpayer advocacy agency cited the gap in creditor reporting requirements as one of the most serious IRS consumer problems in its 2010 report to Congress. “A creditor that issues a Form 1099-C is not necessarily canceling a debt, yet the IRS assumes that Form 1099-C reflects taxable income to the debtor,” according to the report. The taxpayer advocate recommended that the IRS revise the 1099-C form to include a box for creditors to indicate whether a debt was actually canceled. The IRS responded that it would consult its legal advisers.

‘Be aware of it and prepare for it’

The bottom line on 1099-Cs, says tax attorney Green: “Be aware and prepare for it. When you receive that form, go immediately to a tax adviser. Don’t ignore it. That has real dollars and cents consequences.”

Steber, from Jackson Hewitt, warns that the IRS is more advanced at tracking taxpayers’ income. “There is an increased likelihood that if you had one of these events that the IRS knows about it,” he says. “The IRS tracks it back. The IRS is quick to catch up with the person who, for whatever reason, left that [1099-C] off of their return.”

Taxpayers who might have moved and didn’t receive their 1099-C notices in the mail from creditors can’t count on ignorance as a defense: “They will catch up with you,” Steber says.