Most consumers have experienced a financial hardship at some point in their life, and this may have led to the difficult choice to stop paying credit cards for a period of time. Generally speaking, credit card companies often pursue these unpaid credit card debts internally through their collections department. Every financial institution is different, but there comes a point where the decide to write off the defaulted amount, or in other words enter into a cancellation of debt. At this point the debt is often sold to a third party, or collection agency, and they continue to pursue it. Here’s the catch for the consumer. What was considered uncollectible to the bank or credit card company is now viewed as income by the IRS. Here’s what you need to know about debt forgiveness when it comes to tax time.
The Consequences and Exceptions on Forgiveness of Debt
If you or your spouse had your debts forgiven or negotiated for less than the original amounts you will have to treat this as income on your tax return. However, there are several exceptions you can be aware of that may exempt you from the tax consequences of your credit card debt forgiveness.
Filing Bankruptcy: If you file for bankruptcy you will achieve debt forgiveness without recourse when it comes to tax time. This is protected in the current bankruptcy code. Some creditors may still send you a 1099-C by mistake (more on the 1099-C later), but supplying proof of your discharged bankruptcy can alleviate the tax burden of any unpaid debts.
Credit Card Debt Forgiveness During Insolvency: It’s common for people who stop paying credit cards to do so for a reason, often because they run out of money. Being insolvent is a fancy way of saying your liabilities are equal to or less than your assets, so there are exceptions to paying taxes on forgiven debt under this circumstance. However, the timing of your being insolvent must correlate to the time before your debt forgiveness took place.
Business Debts Forgiven that Qualified as Deductions: Lots of small business owners use their credit cards to operate their business. In cases of default, and ultimately forgiveness of debt, you should be exempted on the interest portion of your business credit card debts that were cancelled. This is an important distinction. If you used a personal credit card and this debt was forgiven, you will most likely not be exempt from owing income tax on the 1099-C portion under this exemption. It’s best to check with an accountant on the details of your situation, as we cannot offer legal or tax advice short of understanding your full situation. (Please inquire.)
Debt Forgiveness was a Gift: It’s not likely your credit card company will reclassify your forgiven debt as a gift, but a friend or family member might. If you were loaned money but later told you didn’t have to repay, the IRS will not require you to pay tax on the cancelled debt. This situation will be infrequent due to the fact that you won’t receive a 1099-C from your Uncle or Dad, but tax return filers can understand that they are not required to report this type of forgiven debt as income.
Remaining Mortgage Debt Balances Post Foreclosure: Congress passed an act called the Mortgage Forgiveness Debt Relief Act after the housing market crash. It has been extended a couple of times, so you’ll need to ask your accountant if it is currently in play at the time of this reading. In most cases a debt balance remains between the difference of the property’s value and the amount the bank sold it for at auction. If you originally owed $450,000 and the bank reclaimed only $350,000 from the sale proceeds, you could owe taxes on $100,000. That is a hefty tax bill, but thankfully you may be exempt if the Act is still in operation. Check on this, it’s a biggie!
Some Student Loans: There are special circumstances that apply to some student loan debt forgiveness situations. For example, some student loans have program terms that include forgiveness if you pursue work in a specific field or underserved area. This is a way to incentivize occupations or services that may be under-filled. If this applies to you, any student loan debt you are forgiven will be exempt from income tax.
Special Circumstances-Natural Disasters: From time-to-time Congress passes a temporary stay protecting those who have been affected by a natural disaster that results in personal debt forgiveness. For example, a hurricane or tornado may devastate an area and render many people out of work for an extended period of time. Acts are sometimes adopted to offer temporary relief, and remove the insult-to-injury consequence of tax owed on forgiveness of debt. Keep these exceptions in mind if you find a 1099-C in your mailbox this year.
1099-C: What is it, and Why Do I Need to Care?
The 1099-C is just what it sounds like, a different form of 1099 which documents your income at the end of the year. While it may not be direct income from a job performed, it’s indirect income from a financial benefit received. This comes from any forgiven debts that will now be treated as income by the IRS when you file your taxes. Seem unfair? Yes, it does, but as they say, there is no free lunch-especially with the IRS. They are giving the bank a tax reduction, so they will seek to recover it from you instead.
What about the Credit Card Debt Forgiveness Act?
Unfortunately, there is no current act but many consumers think one exists. Instead, one should consider the exemptions listed above, but ultimately consult with their bankruptcy attorney, legal counsel, and/or tax professional for professional advice. Have you received credit card debt forgiveness and need one-on-one advice? Give the professionals at Brownstone Law Group a call today, and we will help steer you in the right direction when it comes to 1099-C time. Call us for a FREE consultation now: (888) 853-8871
This article has been reviewed and approved by Thomas A. Moore, managing attorney Brownstone Law Group, PC. California Bar # 148698. This article is for informational purposes only, does not provide legal or tax advice of any kind or form any type of attorney/client relationship. This article was published on 12/10/15.