How Canceled Debt can Come Back as a Tax Bill

Dear To Her Credit,

What is the statute of limitations on a canceled debt that is sent to the IRS? We had a canceled debt that was written off in May 1998. We just received a bill from IRS stating that we owe $1,392 because the cancellation of the debt was considered income. It was a collection agency here in Tennessee that turned it in to the IRS at the end of 2010 for 2009 taxes.

I called the IRS, and they didn't know the answer. I looked on the IRS website and many others. It is hard to believe that there isn't a statute of limitations on this. We also didn't receive a Form 1099-C from that collection agency.

Please help or inform me where I can go for help. 


Dear Kim,

Statutes of limitation laws are one thing -- tax on "income" from cancellation of your debts is another. The only relationship between the two is that debts are often written off after the statute of limitations passes and the collector gives up on ever getting the money. That's when the creditor is required by law to report the canceled income to the IRS.

Creditors have wide latitude for deciding when to report canceled debt. According to the IRS website, under "When a Debt is Canceled," they can report it when the statute of limitations expires, when they make an agreement with the debtor to settle the debt for less than the full amount, or when they decide to stop pursuing the debt, for example.

In Tennessee, the statute of limitations for debts is generally six years. (Check the statutes of limitation in other states in this article, "State statutes of limitation for credit card debt.") Your debt is well beyond the statute of limitations for collection by any measure. However, the tardiness of the collection agency in reporting it to the IRS does not get you out of paying tax on the canceled debt.

Look at it this way: You may be upset because the collection agency waited this long to file a Form 1099-C. However, filing it any sooner would only have resulted in you owing the money sooner -- and paying interest and penalties if the tax had been assessed before you got back on your feet and were able to pay.

Don't give up and write a check to the IRS for $1,392 yet, however. With a little research and possibly the help of a tax professional, the outlook may not be so dire.

The IRS allows various exceptions to the rule of paying tax on canceled income. For example, if you never received a benefit from the original debt; for example, if someone else spent the money, you can argue that cancellation of the debt was not income to you. Another exception is if you were "insolvent" -- in other words, your debts exceeded your assets when the debt was canceled.

If you determine that you have a case against your canceled income being taxable, file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness for tax year 2009.

I would also have your tax professional look carefully at your 2009 tax return and see if you can somehow reduce the tax owed. Perhaps when you filed, you didn't owe any tax, so you didn't spend much time looking for more deductions and credits. With the income from Form 1099-C added in, you need every tax benefit you can find.

Do your best to reduce or eliminate the assessed tax, and then pay any tax left as soon as possible. It's the last step in putting old debts behind you and moving on to better times.

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