Many Who Qualify Fail to Take Canceled Debt Tax Exemption


If you had forgiven credit card debt during the past three years and paid taxes on that additional income, you might be eligible for a tax refund -- and not even know it.

How? A national taxpayer advocacy agency says many people who qualify for an exemption to avoid paying taxes on forgiven credit card debt don't take advantage of it. The IRS tax forms and publications are so confusing that many people -- whose lives may be in financial upheaval because of debt -- just give up and pay the taxes.

"Unfortunately, it's complicated and daunting for people to get through," says Annette Nellen of the American Institute of Certified Public Accountants.

Tax experts say it's not too late for some affected debtors to fix the oversight. Anyone who missed the chance to get the exemption in the 2008, 2009 or 2010 tax years can still do so by filing amended returns. They remind anyone doing their 2011 taxes to seek professional tax help and do the necessary calculations to figure out if they can avoid paying taxes on forgiven credit card debt.

Low-income families 'burdened'

According to the IRS, if you received a 1099-C tax notice that you had "income" from canceled or forgiven credit card debts, you may not have to pay taxes on some or all of that income. If your liabilities exceeded your assets when you settled the debt, then you were insolvent, according to the IRS. Insolvency is one of the key avenues for avoiding paying taxes on canceled credit card debt. Yet, studies show low-income families most likely to meet the insolvency criteria don't take the exemption.

"There are some people who are so far in debt and they don't have a lot of assets," says Nellen. "They don't have a house. They don't own a car. For them, it's pretty clear that they are insolvent. For others, it's a lot more complicated."

Not filing for the exemption means some people may have higher tax bills and may also reap fewer benefits from tax credits for lower income working families.

"Taxpayers may not understand that they are not required to include canceled debt in income if they were insolvent when the debt was canceled," according to Nina Olson, head of the National Taxpayer Advocate Service, a citizen watchdog division of the IRS.

Olson's 2010 annual report to Congress identified several ongoing problems with canceled debt income and taxes, including creditors reporting the wrong amount of canceled debt to the IRS and debt collection continuing on canceled debt that placed a "burden" on taxpayers. (See story, "Canceled debt tax reporting rife with problems").

Confusion about who does or doesn't have to pay taxes on canceled debt income and whether the reporting requirements are fair to consumers comes at a time when canceled debt tax notices have skyrocketed. According to IRS data,  fewer than 1 million people received canceled debt tax notices in 2003. Since then, that number has more than tripled -- to 3.9 million in 2010. The IRS projects some 6.3 million notices may be issued for the 2011 tax year.

1099-C tax notices don't always mean income is taxable

At issue is the so-called 1099-C tax notice. Whenever borrowers pay less than the amount owed on a credit card or other debt, the difference between what they paid and what was owed -- or the amount forgiven -- is considered income by the IRS.

For example, if you had $10,000 in credit card debt and negotiated with the creditor to settle the debt by paying only $5,000, the remaining $5,000 may be considered taxable income.

Banks, credit unions and other creditors are required to send debtors and the IRS 1099-C notices showing the amount of the forgiven debt. Depending on the individual's income level, deductions and tax bracket, they may owe taxes on that canceled debt "income."

However, the tax code spells out exemptions that allow certain debtors to avoid paying taxes on canceled debt.

"People get these forms and, of course, the natural reaction is it has to go on my taxes," says Nellen, a professor of taxation at San Jose State University. She points out that not all 1099-C "income" is taxable. Debts that were discharged through Chapter 11 bankruptcy are exempt. Another way around the tax bite is to show you had more debts than assets just before your credit card debts were canceled.

Insolvency exclusion rarely used

"One of the reasons you can exclude that cancellation of debt income is that you're insolvent," says Nellen. "You can only exclude it up to the amount of your insolvency."

That means that if, in the example of the $5,000 of forgiven debt income, the individual had total assets valued at $50,000 and liabilities totaling $53,000 just before the credit card debt was canceled, their finances were under water by $3,000. The $5,000 canceled debt income would be reduced by the $3,000 insolvency. Only the remaining $2,000 in forgiven debt would be reported on the tax return as income. If the person was insolvent by $5,000 or more, then all of the canceled debt income would be exempt from taxation.

In order to take advantage of the insolvency exemption, however, taxpayers must fill out and attach IRS Form 982 along with the 1099-C to their federal income tax return. IRS Publication 4681 includes a worksheet to help log liabilities and assets and calculate whether an individual was indeed insolvent.

"It's complicated to go through and figure out if you're insolvent," says Nellen. People deep in debt may say, "'Hey I had bills I had to pay,' but that doesn't mean you were insolvent. You might have some assets that you weren't thinking about."

Assets minus liabilities

Figuring out insolvency means going through your jewelry, clothing, books, DVDs, lawn tools and everything else you own and placing a fair market value on those items. Then, add up all of your outstanding debts and obligations, including any outstanding and overdue child care or utility bills. If you subtract the liabilities from the assets and get anything less than zero, you're insolvent.

Adds Nellen: "If you asked the average person on the street, 'Are you insolvent?' they would say, 'I think so,' but they might not be."

The taxpayer advocate's review found lower than expected numbers of people claiming insolvency. In a random sample of 380 taxpayers who filed 1099-C forms with their 2008 tax returns, the tax advocate found that nearly half of them (47%) had adjusted gross incomes of less than 250% of the federal poverty level. That meant they were low-income and probably would have qualified for the insolvency exemption.

Only about 1 in 10 file for exemption but half are low-income

Yet, IRS records requested by show only 7.6% of the 1099-C notices issued in 2008 were accompanied by Form 982 to exempt the canceled debt from taxation. Similarly, in 2009, although creditors issued nearly 2.7 million 1099-C notices, only 11.6% of those filed for exemptions.

The IRS sends taxpayers who fail to report the 1099-C income on their tax returns a "Notice CP 2000." That letter is the first step toward the IRS assessing a tax based on the full amount of the forgiven debt -- regardless of whether the person may have qualified for an exemption.

When the taxpayer advocate's office looked at a sample of tax returns that were flagged by the IRS and issued CP 2000 notices for not reporting 1099-C income, it found further evidence that taxpayers are confused about how to claim an exemption from the tax.

Both Nellen and the taxpayer advocate point out that families under stress from the economic slowdown and deep in debt may be too distracted with other life demands to struggle through the complicated 1099-C tax reporting rules. They also may not be able to afford to take their tax problems to professional tax preparers.

"Obviously, if they were having tough times, you might not expect that they were paying attention to everything," says Nellen. "They just might not be aware of it."

According to the tax advocate, taxpayers who get IRS notices solely for not reporting 1099-C income often just give up and agree to pay the tax. The advocate reviewed a random sample of 71 IRS CP 2000 letters and the tax returns associated with them. Nearly all had claimed the Earned Income Tax Credit (EITC) and had low incomes -- indications that they would have likely qualified as insolvent and exempt from taxation for canceled debt. Still, nearly half of the 71 taxpayers never responded to the IRS notice and about the same amount responded but agreed to the tax assessment.

"Both of these measures suggest that taxpayers may not understand that they are not required to include canceled debt in income if they were insolvent when the debt was canceled," the advocate wrote in its 2010 report to Congress. "IRS initiatives to identify insolvency would benefit these taxpayers, especially because the cancellation of debt income, in addition to increasing adjusted gross income, reduced or eliminated the earned income tax credit that most of these taxpayers claimed. The average amount of lost EITC was $893 for the 71 taxpayers that were issued a Notice CP 2000 solely because they reportedly had cancellation of debt income."

In its response to the tax advocate's report, the IRS says its workers look for evidence of bankruptcy before sending a CP 2000 notice, but generally cannot determine if a taxpayer is insolvent based solely on data available to the IRS. "... Using income alone as an exclusion criterion is not a valid indicator of taxpayers' assets and liabilities," the IRS wrote. The IRS revised the CP 2000 notice to include a paragraph telling taxpayers that anyone claiming insolvency should include a breakdown of their total assets and liabilities.

Amending returns no easy feat

Nellen and other tax experts warn that it may not be easy for anyone contemplating amending past returns to recoup any tax losses. They must go back, perhaps several years, and show that they were insolvent "immediately before" the debt was canceled, as the IRS rules indicate. The IRS allows taxpayers who believe there were errors on their returns to make corrections and resubmit the forms if they do so within three years of filing the original return or within two years of paying taxes on the return, whichever comes first.

"We recommend any taxpayers who received a Form 1099-C in tax years 2008, 2009 and 2010 see a tax professional to discuss if they qualify for insolvency and should amend their tax return," says Mark Steber, chief tax officer for the Jackson Hewitt tax preparation service. "Since the income on a Form 1099-C is included on the tax return unless the taxpayer qualifies for an exception, this would increase their adjusted gross income (AGI) and that usually reduces or eliminates an Earned Income Tax Credit."

Steber notes that taxpayers will "need the original and any previous amended returns, to create the amended tax return."

He added: "Many taxpayers do not keep copies of their tax returns, but their tax professional can help them get a copy from the IRS, or from the preparer that originally did their tax return."

Is it worth it to amend?

"It's not impossible, but the more time that passes, it's hard to go back and really prove that you were insolvent," Nellen says. "They have to show what was the value of their assets, what were their debts at that point in time."

"To dig out all those records and the added complication of doing this well after the fact" makes filing the amended return a tough call, Nellen says.

If you get past the documentation hurdle and do the worksheet to determine that you were in fact insolvent just before the debt was canceled, the next step is adjusting the tax return. A change in the adjusted gross income might then impact the amount of any child tax credits, higher education credits and earned income tax credits (EITC).

"There are so many different pieces that have a ripple effect on other parts of your tax return," Nellen says.

In addition, people who live in states that require state income tax returns may also have to amend those returns -- adding to the paperwork.

In the end, that 1099-C may be a reminder of a difficult financial period that taxpayers would rather forget.

Once the numbers are calculated, the taxpayer may not realize a significant refund or savings, Nellen says. If you didn't owe any tax or the forgiven debt income was very small, "it's probably not worth going through that," she says.

Other on the hand, someone who had significant debt written off but were unaware they may have qualified for the insolvency exemption might reap the benefits of amending their tax return.

Adds Nellen: "Once they get the data, they can run the numbers fairly quickly and rerun the return."