Beware of IRS tax bite that may follow canceled debt

Consumers who thought they'd seen the last of their financial problems when they negotiated with credit card issuers or debt collectors to pay off a portion of their outstanding debts are finding their money woes may be far from over.

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

Many months after successfully resolving credit card debts, consumers are receiving 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 April 15.

Surprise tax problemThe 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 blind-sided 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 doubled between 2003 and 2008. The IRS received a little under 1 million forms in 2003 and more than 1.987 million in 2008 The projected number for 2009 is 2.5 million (see chart). 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.

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 resolution 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 immediatelyConsumers 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.

Homeowners who default on mortgage loans may also qualify for exclusion of their foreclosures under the Mortgage Forgiveness Debt Relief Act, which took effect Dec. 20, 2007, to help homeowners caught in the mortgage crisis.

Other exclusions are for certain farm debt, student loans and real property business debts.

Informing consumersMuch 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 top five 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.

"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."

She says debt buyers have been sued for the unlicensed practice of law after giving consumers advice on resolving their debts. It's something she advises her members to avoid. "A debt buyer is not the consumer's financial planner," she says. "Everybody's financial situation should be discussed with a tax adviser."

Knowing the amount of forgiven debt to be reported to the IRS would help consumers plan ahead, Sinsley says. "When they are negotiating the settlement of the debt, the consumer can discuss with their tax adviser what consequences there would be in exchange for the settlement of the debt," she says. "If the consumer is settling a debt and they know the settlement is X and the forgiveness is Y, they can go to their tax preparer and say, 'If I do this, what is my tax impact?' "

Roni Deutch, a tax attorney and founder of the Roni Deutch Tax Centers, a North Highlands, Calif.-based chain of franchised tax preparation services, says debt resolution specialists and credit counselors who help millions of consumers negotiate settlements to reduce their debts should do more to educate consumers about the tax implications. "They do a great job. All I'm saying is go one step further," Deutch says.

She says the IRS, too, must do more to explain the 1099-C forms to debtors in easy-to-understand language. According to IRS spokeswoman Theresa Branscome, the IRS has released numerous publications and bulletins about 1099-Cs. However, many of those publications have focused on mortgage forgiveness rather than credit card debt.

Deutch cites her own experience with credit card debtors as evidence of the need for more information on resolving credit card debt. Just a few years ago Deutch says only 1 in 10 of her tax clients had 1099-C problems. "Now one half of my clients are dealing with this," she says, adding taxpayers often find administrative costs may be added in to the 1099-C on top of the amount of forgiven debt. "That's the real injustice here," she says.

Check the figuresAnother tip from tax preparers: Make sure that the amount of canceled debt listed on the 1099-C form is accurate.

"Make sure that you agree with the numbers," says Steber from Jackson Hewitt. "They can include interest on the debt that hasn't been paid for a while." If there is a discrepancy, Steber says, "You better go back and talk to them now and find out what it is."

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."

Consumers who receive 1099-Cs in error may request that creditors or debt buyers send corrected forms to the IRS, but the situation leads to confusion and complications for consumers, according to the law center.

Several tax advisers called the 1099-C requirements unfair to consumers trying to overcome mountains of debt. Others say the tax rule is further proof that there is no free ride and consumers who borrow money must be prepared to live up to their financial obligations.

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."

To comment on this article, write to: Editors@CreditCards.com.

More from CreditCards.com: