Last Thursday I ran a post that discussed the grim state of the credit card business. In it I discussed a New York Times article about consumers settling their credit card debt for less than what was owed. I even passed along some simple negotiating tips.
One thing I (and the Times) failed to mention is that if you settle your $3000 credit card debt for $2000, the $1000 that was written off by the credit card company is often considered taxable income. You will get a 1099 on it and come next April 15 you will either have to pay taxes on it or file a special form to explain why you don’t have to pay taxes on it. (This is discussed in detail in a great post at Don’t Mess With Taxes inspired by the same Times article.)
That it may be taxable doesn’t quite seem fair, does it? You’re broke, you manage to convince the card company to be "reasonable" and then Uncle Sam wants a cut. Actually, it’s not completely nuts. You really are up $1000. You got $3000 of stuff (and interest payments) for $2000. And the $1000 reduces the card company’s taxable income, so it seems mildly reasonable it might increase yours.
Of course, any attempt to understand the tax code through reason and logic is bound to end in tears. Not all types of forgiven debt is taxable, and under some circumstances forgiven credit card debt is not taxable as well.
Home mortgage debt that is forgiven is not taxable, at least for now. This is a relatively new development, enacted originally with the Mortgage Debt Forgiveness Act of 2007 and expanded under 2008′s Emergency Economic Stabilization Act. Current law has the exception running until 2012.
That forgiven mortgage debt is treated more favorably than forgiven credit card debt is yet another reason why the received wisdom that you should never ever borrow on your house to pay off credit card debt is not necessarily true.
Situations in which forgiven credit card debt is not taxable include debt erased in bankruptcy proceedings and debt forgiven while you are "insolvent". And what does the IRS mean by insolvent? Well, according to their website "You are insolvent when your total debts are more than the fair market value of your total assets."
I’m having trouble picturing a situation in which a card company would agree to settle for less than it was owed and you weren’t insolvent. Alas, the IRS has its own peculiar ideas. You can find out more in publication 4681 Cancelled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals). Of note is that for the purposes of this insolvency calculation, you include assets such as IRAs that are not normally touchable by creditors. Which makes no sense, but then why would we expect it to?
Even as the tax code goes, this is a particularly murky area. As Don’t Mess With Taxes points out, the confusion over this was listed by the National Taxpayer Advocate in her annual report to Congress as one of the most serious problems encountered by taxpayers. Her concern is that any reasonable person receiving a 1099 in the mail for the forgiven debt will just resentfully pay taxes on it, not knowing that they might be considered insolvent and should instead file form 982.
If you have had debt forgiven, you will almost certainly need the help of an accountant or lawyer specifically knowledgeable about this dark alley of the tax code. The problem being that those sorts of experts don’t work for free, and if you are broke enough to have debt forgiven, then, well, you get the idea.