Forgiven Debt is Taxable Income

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.

Credit Cards, Housing, Taxes | Frank Curmudgeon | June 22, 2009 9:00 am

174 Comments

By Kosmo @ The Casual Observer, June 22, 2009 @ 9:38 am

I can understand including IRAs in the insolvency calculation, since you could conceivably raid your IRA to pay down debt. I guess I’m looking at it from the ability of the taxpayer to be solvent, not the ability of the BK court to pay all debts from available BK assets.

Although I’m not sure why the solvency should affect the taxability. If you received a benefit, it should be taxable.
By Dave C., June 22, 2009 @ 9:51 am

Even if the person was taxed and they were insolvent, will it really matter? I’m ignorant on this, but what can the IRS do if you have nothing and owe taxes? We don’t have debtor prisons anymore, right?
By Kosmo @ The Casual Observer, June 22, 2009 @ 10:17 am

Dave – wage garnishment.
By Jon @capitalistmaven.com, June 22, 2009 @ 10:50 am

“You are insolvent when your total debts are more than the fair market value of your total assets.” Wow that is a broad definition. Based on this definition I know plenty of people who are insolvent. Most students who have lots of student loans but no savings would be insolvent. Someone with little savings who buys a new car is likely to be “insolvent” the moment they drive the car off the lot. And just think about how many homeowners with negative equity could be classified as “insolvent”?
By gpr, June 22, 2009 @ 5:00 pm

“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.”

Not to move the conversation back four places, but this paragraph might be a good example of why the “gurus” sometimes simplify or do not clearly explain. Your paragraph reads almost like you’re recommending getting mortgage debt forgiven as a sound financial strategy.
By Frank Curmudgeon, June 22, 2009 @ 5:17 pm

Kosmo: I guess I think of the insolvency test being a sort of bankruptcy-lite, which is why its different asset rules confuse me. And I agree with you on the principle that if forgiven debt is taxable it should be taxable regardless of how broke the debtor is. But as a practical matter there is a blood-from-stone problem here. If they couldn’t pay the creditor then they can’t pay Uncle Sam.

GPR: I mean only that this is another small way in which HELOC debt is not horrendously worse than credit card debt. And it’s not just the gurus: never swap CC for HELOC is pretty mainstream advice. Of course debt forgiveness is not a financial strategy. But remember that the CC/HELOC argument is all about what happens if you don’t pay.
By Phil, June 23, 2009 @ 4:33 am

It is entirely fair that you are taxed on debt forgiveness. You borrowed money, failed to return it and now the lender is essentially giving you the money to retire the debt. That’s income.

With respect to mortgage debt: it’s well known the tax code is slanted towards home ownership. The forgiveness of mortgage debt not being income is entirely consistent with the deduction of mortgage interest. We (humans – not just the U.S.) use our tax code not just to fund government, but also to provide incentives to the populace to do the right thing – gas tax to drive less and conserve fuel, cigarette tax to reduce smoking a be healthier, tax breaks to encourage home ownership, among many, many other instances.

These are the issues that, in my opinion, define a true liberal vs a true conservative: whether you think the preceding is proper or improper government, respectively.

If the choice between the two systems is obvious to you, then you haven’t thought hard enough about it. ; )
By Darkside, June 23, 2009 @ 10:46 am

If you have $3000 in CC debt and you settle for $2000, you didn’t have $3000 in “stuff”. I’ll wager that by the time a CC comapny is willing to settle, you’ve racked up a significant percentage of balance in fees, interest and penalties. I don’t see late fees and interest payments as income, because you did not receive any asset in trade. Now, if you have a $3000 debt and you settle for $2000, you should have the fees and interest also discounted before you rack up taxable income. So, if you have a $3000 debt, which is $2500 principle balance and $500 of late fees and interest, you settle for $2000, your taxable income on a 1099 SHOULD be $500. I just don’t see how it’s fair to call those crazy fees “taxable income”.
By Dave, January 31, 2010 @ 10:27 am

I read that if part of the forgiven credit card debt is interest, the interest is NOT included as income if the interest was NOT deductible in schedule A Itimized deductions. I received several 1099-c from financial institutions and none of them showed what part of the foregiveness was interest as they are required to do. Is there a way to get the banks to show teh interest part or is the interst part what they consider forgiven first and the balance is the actual debt?
By FactScanner, April 17, 2010 @ 9:18 pm

What if the credit card was used to pay for medical expenses or treatment, medical bankruptcies are very common, in this case what will happen?
By Rrats1962, December 15, 2010 @ 9:08 am

What if you use a debt solution company, are their fees and commission deductible? They are the cost of creating the income. (or paying off the debt).
By Rosalind Walker, January 28, 2012 @ 11:08 am

What if your married and the credit card was in a bankruptcy that was dismissed and my husband is unemployed and we did not live together at the time he filed bankruptcy, the credit card is over 8years old and is no longer on his credit report and we just received a forgiveness of debt in the mail from the IRS and we never received a 1099c. Im the spouse that worked and its his indvidual cc and individual bankruptcy that had been dismissed.
By Rosalind Walker, January 28, 2012 @ 11:11 am

The cc was charged off in 2002?
By David Philbert, March 17, 2012 @ 12:05 pm

If a creditor has accepted funds as payment in full on a loan and has reported the balance as forgiven, can they still charge it off and retain a collection agency to seek settlement?
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