Editorial Policy

Do You Still Owe Taxes on Forgiven Debt?

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By Eva Norlyk Smith, Ph.D.
April 13, 2011

Millions of consumers who negotiated a debt settlement on a credit card balance may be surprised to find that they are not out of the woods after all. Their card issuer may have written off their bad credit card debt; but, unfortunately, Uncle Sam has not.

Many consumers don’t know that the IRS levies taxes on canceled debt. It’s not just bad credit card debt that’s at issue. The government classifies any type of forgiven debt more than $600 as taxable income. This includes mortgage foreclosures (but it doesn’t include canceled debt on a consumer’s principal residence for foreclosures taking place between 2007 and 2012).

By the time consumers sit down to fill out their tax returns, they are often caught off-guard by how much they have to pay. “Nine out of ten people have no clue about this,” says Chris Strand, Director of High Networth Services at Bader Martin, in Seattle Washington. “They make a settlement for their credit card debt, and then suddenly, they have taxable income! It’s difficult for many people to understand that concept.”

According to the IRS, when a loan obligation is forgiven, the amount canceled becomes reportable as income because there is no longer an obligation to repay the loan. So, if a consumer with $20,000 in credit card debt settles on the debt and pays only $5,000, the IRS counts the $15,000 in canceled debt as taxable income.

However, there are a few exceptions to this rule. Consumers don’t have to pay taxes on debts discharged during bankruptcy, and consumers who are insolvent — meaning, their liabilities exceed their assets prior to the cancellation of the debt — are also exempted.

Lenders are required to report canceled debt to the consumer and the IRS on Form 1099-C. Not surprisingly, the number of “Cancellation of Debt” forms filed with the IRS has skyrocketed over the last few years. The number of 1099-Cs filed between 2003 and 2009 jumped from fewer than 1 million to more than 2.6 million. The IRS projects that 1099-C filings will rise to 3.1 million by 2012.

Tax obligations on settled credit card debt
The timing of when and how taxes come due on credit card debt differs somewhat, depending on how the debt is discharged.

Many consumers mired in credit card debt opt for a formal debt settlement to get out of their debt obligations. When a credit card debt is settled, the tax consequences are pretty straightforward: The consumer is liable for taxes on the total amount of forgiven debt and must report the amount canceled as income for that tax year.

Unfortunately, many consumers discover too late that there is an additional fallout from the debt they thought they had settled. To avoid this predicament, consumers should plan around the tax obligations when entering a debt settlement, experts recommend.

“If you’re negotiating a debt settlement, it’s important to take the tax consequences into account before reaching the final agreement,” says Harrine Freeman, author of “How to Get Out of Debt and Get an A Credit Rating.” “Before settling, ask if the company will be sending out a 1099-C. If they will be, then take that into account when determining how much of the debt you can afford to pay.”

Tax consequences of credit card defaults
When it comes to credit card defaults — in which people walk away from the debt without negotiating a settlement — the tax consequences of the debt are a little more complex.

Card issuers typically try to collect the unpaid debt for six months or longer, but eventually they write off the debt as a loss on their books and sell the debt collection agencies for pennies on the dollar. However, even though the credit card issuer writes off the debt as collectible, the IRS doesn’t consider it canceled debt, as long as the debt is still being collected.

“The debt is still referred to as an ‘open transaction,’ meaning it hasn’t closed,” explains Bader Martin’s Chris Strand. “You can’t determine the tax treatment until you have a closed event. As long as collections agencies are still trying to collect it, it’s a valid debt, and not subject to taxation.”

Technically, a person continues to owe the credit card debt until the statue of limitations runs out. However, at some point, even collections agencies give up on collecting a debt. By then, they may or may not send a letter to the consumer stating that the debt has been canceled and issue the consumer a 1099-C Form.

“Many debt collection agencies don’t even bother sending out 1099-Cs when a debt is canceled,” explains Strand. “Those companies come and go, and in many cases, compliance is not a main concern. If you don’t get a 1099-C, it probably hasn’t been reported.”

Overlooking a 1099-C form, however, could have unpleasant consequences.

“Very often tax payers don’t know what to do with the 1099-C form, because it’s not a form tax payers see a lot of,” says Gil Charney, Principal Tax Researcher at the Tax Institute at H&R Block. “Many people end up putting it away and forget about it. Of course, that could lead to penalties down the road, so it’s very important to report that income.”

In short, when settling a large amount of credit card debt, it’s a good idea to get professional help. A tax adviser is essential to understand the tax implications of settling a debt before the agreement is finalized. A good tax adviser can also help determine if a consumer qualifies for exclusions that might lower the taxable income from the canceled debt. And make sure the information is correct: If the amount on your 1099-C isn’t what you actually negotiated for, request a corrected form from your lender.