Are You Forced to Pay Taxes on Scammed Income?

It happens every day: consumers fall victim to scams and lose some--and in the worst cases, all--of their hard-earned money.

I recently saw an article in which a New Jersey couple had a balance of almost $5,000 run up on their credit card by a fraudulent travel agency. The scammers in this case were identified, arrested, stood trial and were found guilty. After fighting with their bank over the falsified credit card charges, the article reported the couple’s bank finally backed out the charges.

But that wasn’t the end of the saga. In January of the following year, the couple reportedly received a Form 1099-C from the bank for debt forgiveness for the amount of the charges it wrote off. Because the bank was unable to recover the money from the travel agency, it classified the charge as cancellation of debt to the scammed couple. Any forgiven debts more than $600 must be reported to the IRS.

Because of the bank’s decision, the couple was required to report the “cancellation of debt” as income on their federal income tax return and pay the corresponding taxes. There was a reportedly lengthy battle between the couple and the bank that ended in an undisclosed resolution.

Many consumers are unaware that some banks may force scam victims to pay taxes on any money returned. If no money is ever recovered, the bank is forced to report this amount of money to the IRS.

Scambook.com, an online consumer advocacy platform, is warning scam victims about this, and is three tips to help consumers facing a similar tax scenario if their bank or credit card company returns money after a scam:

1. Contact the financial institution's customer service or legal department. Be persistent and ask to receive written notices detailing the bank or credit card's charge back policies.

1. Keep a paper trail of all communications with the financial institution.

1. Consult an enrolled agent, financial advisor, certified public accountant or tax attorney to assess options.

If you cannot resolve the 1099 issue with your credit card company, I would suggest showing the loan forgiveness as other income Line 21 of your individual income tax return then write off the same amount on Schedule D as bad debt from the scammers.  If the income is classified as debt, then let it show as debt from your standpoint as well. It’s a funky way to do it, but the logic is there and I feel with proper documentation it will stand up in audit.

According to Miranda Perry at Scambook.com, “We believe that consumers shouldn't be penalized with financial or personal burdens, such as the potential cost and headache of filing extra tax forms, if they have the misfortune of falling victim to a scam.  We wanted to draw attention to this case so that consumers can be aware of this possible outcome when they're filing a dispute with their bank or credit card company. Our hope is that consumers can work with the financial institution to make arrangements so any money they receive after they've been scammed will not be categorized as a forgiven debt.”