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.

Avoiding 1099-C tax problems

What you should know: Have you negotiated with a creditor to pay less than you owe on a credit card debt? The IRS considers forgiven or canceled debt as taxable income.

What to do: Experts advise consumers to seek tax advice before negotiating credit card debt settlements to avoid a “surprise” tax hit from cancellation of debt.

For many consumers with debt problems, after the debt collector leaves their lives, the taxman arrives.

Months after successfully resolving credit card debts, consumers have received 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 who 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 “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.
“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 is growing as the amount of bad debt rises amid a nationwide credit crisis.

According to the IRS, the number of 1099-C cancellation of debt forms filed with the federal government by creditors and debt collectors nearly tripled between 2003 and 2009. The IRS received fewer than 1 million forms in 2003 and more than 2.673 million in 2009 The projected number for 2010 is 2.8 million (see chart). The IRS expects to get 3.1 million debt forgiveness forms by 2012. Part of the spike may be due to the rise in mortgage foreclosures, but a major portion of it is also attributed to credit card debt.

Debt forgiveness leads to rise in 1099-C filings Canceled and forgiven debt may be taxable income for some consumers. According to the IRS, the number of taxpayers filing debt cancellation forms nearly tripled between 2003 and 2009. The IRS estimates the volume of filings will continue to climb into 2012, when they will hit a projected 3.11 million. Source: Internal Revenue Service, Analysis and Statistics, Office of Research, Forecasting and Service Analysis

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.

Seek advice immediately

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, vice president of tax resources 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 income if you don’t meet one of the exceptions,” says Eric L. Green, a tax attorney with the Convicer & Percy law firm in Glastonbury, Conn.

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 excluded as income. “The remaining $3,000 would be reported under other income,” says H&R Block’s Flores.

Debt Resolution Tax Tips: What Every Consumer Should Know

Dealing with debt can be stressful, and tax rules often make it even more confusing. If you settle a debt for less than you owe, you may receive a 1099-C form for canceled debt. That amount may be considered taxable income. These tips will help you avoid surprises and stay prepared during tax season.

Essential Tax Steps Before Settling Any Debt

1. Talk to a tax adviser
Before finalizing any debt settlement, consult a tax professional who understands 1099-C forms. They can explain how the settlement may affect your taxes.

2. Confirm the amount that will appear on the 1099-C
Ask the creditor or debt collector to tell you exactly how much canceled debt they will report. This removes confusion later.

3. Watch for the 1099-C form
The form usually arrives early in the year. Do not ignore it. Give it to your tax preparer as soon as you receive it.

4. Fix errors immediately
If the amount on the form looks wrong, contact the creditor right away. Ask for a corrected 1099-C to avoid problems with the IRS.

When Canceled Debt May Be Excluded From Taxes

Some forgiven debts qualify for exclusions. For example:

• Mortgage debts forgiven between 2007 and 2012 under the Mortgage Forgiveness Debt Relief Act

• Certain farm debts

• Some student loan debt

• Real property business debts

Ask your tax adviser if your situation qualifies.

Why Consumers Often Get Surprised by 1099-C Forms

Many people are shocked when they learn that forgiven debt may be taxable. Tax professionals say this confusion happens because creditors rarely explain the tax impact.

According to Wells Fargo spokesperson Lisa Westermann, the bank includes 1099-C information in settlement letters. However, many other credit card companies do not clearly communicate these tax rules.

As Connecticut tax attorney Green notes, banks do not see it as their responsibility to give tax advice. Debt buyers agree. Their industry group states that no law requires them to warn consumers that a 1099-C will be issued after a debt settlement.

Debt buyers also avoid giving tax advice because doing so may count as unlicensed legal practice. Instead, they encourage consumers to discuss all financial decisions with a tax professional.

IRS Focus and Common Issues With 1099-C Forms

IRS publications explain 1099-C rules, but much of the guidance focuses on mortgage forgiveness, not credit card debt. This leaves many consumers confused.

Check the reported amount

Make sure the canceled debt listed is accurate. As Jackson Hewitt’s Steber notes, creditors may include unpaid interest, which can increase the amount.

Are 1099-C Rules Fair?

Some tax advisers believe the rules are unfair for people trying to rebuild their finances. Others argue that canceled debt is still income and should be taxed like any other financial gain.

The Bottom Line: Don’t Ignore a 1099-C

Tax attorney Green offers clear advice:
“Be aware and prepare. When you receive that form, go straight to a tax adviser. Don’t ignore it.”

Canceled debt has real financial consequences. Staying informed can help you avoid penalties and unexpected tax bills.