Forgiven Debt Really is Income

There was a pretty good post over at WiseBread yesterday on how if a credit card company forgives some of what you owe, what was forgiven is income 1040 you have to pay taxes on.

On the one hand, this is a point worth repeating because it seems to surprise most people. On the other hand, the post neglects to mention an important exception, and, moreover, feeds into the belief that this is an irrational fluke of the tax code. It isn’t. It makes sense.

You owe Credit Card Corporation (CCC) $5000. Realizing you are unlikely to pay them back in full, and now regretting lending you the money to begin with, CCC agrees to settle the debt for $2000 cash. You sell your PEZ dispenser collection on eBay and send them a check.

You are $3000 better off than you were before the deal. You went from owing $5000 and having $2000 in PEZ dispensers, a net position of negative $3000, to being flat. If it had been the other way around, if you had had $5000 in PEZ dispensers and swapped them to clear a $2000 debt, you would have undoubtedly complained about losing $3000.

What is more, and I think this a key point as far as the IRS is concerned, CCC will book a loss of $3000 that will reduce their income for the quarter. To the IRS, there is a sort of Newtonian law of conservation of gains and losses. If a person or company is booking a loss, then somewhere somebody else must be booking the equal and opposite gain. If CCC took a loss, you need to take a gain.

Are there exceptions to this? Of course. In fact, there are lots of them. Three of the more significant ones are debts discharged in bankruptcy, debts forgiven while you are insolvent, and forgiven home loans. (Details of other exceptions can be found here.)

The exception for bankruptcy is, I think, based on practicality rather than any logical principle. A person unable to pay his debts is unlikely to be able to pay the government additional taxes. An extension of this idea is that debts forgiven while you are insolvent, as the IRS defines it, are excluded from income. As I wrote a few months ago, this is an exception that probably applies to many people with forgiven credit card debt and yet is not widely known and rarely mentioned in such places as blogs. So many people pay more to Uncle Sam on forgiven debt than they need to.

Debt secured by your house, a mortgage or home equity loan, that is forgiven is also excluded from income. This exception is relatively new, it was enacted in 2007, and, you may be surprised to hear, actually makes sense and makes the tax code more consistent.

Imagine you were to buy an asset or investment other than a home with borrowed money, let’s say a dry cleaners for $500K [with $400K borrowed]. After a few years you realize the business just isn’t working out. The dry cleaners is now worth only $300K. The lender agrees to a short sale, that is, you will sell for $300K, give that amount to the lender, and they will forgive the rest of the loan.

Under this scenario, you would get a gain of $100K from the forgiven loan, but you also have a $200K loss from selling the business. That nets out to a loss of $100K, which is, in fact, what you were really out on the deal.

The problem is that until 2007, if you did this with a house rather than a dry cleaners you would end up with a $100K taxable gain. Losses on houses cannot be taken off your income for tax purposes. (No whining: gains on houses up to $500K for a couple aren’t taxed at all.) With no offsetting loss to declare against the forgiven loan, you would wind up paying taxes on the $100K, even though you actually lost money on the house. Excluding forgiven home debt fixes this problem.

I’m not sure why the fact that forgiven debt is generally considered taxable income is surprising to so many. Perhaps the psychology is that if you know you can’t pay the $5000 to CCC, when they give in and accept $2000 you don’t think of them doing anything other than acknowledging the obvious. $2000 was about all you were ever going to pay them, so getting them to agree doesn’t seem like a gain to you. Alas, it is.

As I said when I last discussed this topic, this is a murky area even by the obscure standards of the IRS code. If this is a more than academic question in your life, seek the assistance of a pro.

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