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.

No Comments

  • By Patrick, September 23, 2009 @ 12:44 pm

    I don’t buy an argument that says treatment of personal taxes is fair by comparison to corporate taxes. They are two fundamentally different beasts. One company can have expenses of $1M per year and another $1B. Both are legitimate businesses with legitimate expenses. However, one person might have a lifestyle that costs $30k and another $30M. The latter shouldn’t be given tax relief for having chosen a more expensive lifestyle.

    I’d say the current rule is more fair not by comparison with business tax rules, but by the mere fact that it makes no sense to charge someone for a capital gain but disallow them from claiming a capital loss on the same asset at the same time. That just defies logic.

  • By Tony, September 23, 2009 @ 2:48 pm

    “I’m not sure why the fact that forgiven debt is generally considered taxable income is surprising to so many.”

    I’m sure it goes hand in hand with the mindset that says that a creditor is “greedy”, “predatory”, or otherwise “bad” for expecting you to repay what they’ve lent you.

  • By Mr. ToughMoneyLove, September 23, 2009 @ 3:05 pm

    If you are a vendor/lender to a deadbeat customer/borrower, be sure to send them and the IRS a 1099 for any amounts you write off. It puts the deadbeat on the hook for the taxes. A small bit of revenge.

  • By Neil, September 23, 2009 @ 3:29 pm

    “I don’t buy an argument that says treatment of personal taxes is fair by comparison to corporate taxes.”

    I don’t think anyone said that. On your personal taxes you have to declare gains and can write off losses…nothing to do with business taxes.

    This seems like a lopsided policy, what with only having to declare gains over 1/2 million on your house, but being able to effectively write off any loss. But since it benefits the little guy at the expense of the rich, I don’t really have much probablem with that.

  • By Kevin, September 23, 2009 @ 6:51 pm

    Something in the numbers seems off to me. It looks like there should be a $400k in there somewhere to yield a $100k loss.

  • By My Journey, September 23, 2009 @ 7:20 pm

    I didn’t know about this until my brother went through it. I ghost wrote a letter for him citing that he never accepted liability, and based non-payment on the Disputed Doctrine exception. The settlement papers didn’t say anything about admitting fault.

    IRS rejected it pretty quickly lol, and since it was a tax liability of $800 it wasn’t worth fighting it. But I think for a larger bill, depending on the merits of the case there are circumstances where it would be worth fighting the 1099-C.

    http://www.myjourneytomillions.com/articles/cancellation-of-debt-may-be-taxable-income/

  • By Dan, September 24, 2009 @ 6:51 pm

    “I’m not sure why the fact that forgiven debt is generally considered taxable income is surprising to so many.”

    I think because most people in this situation live paycheck to paycheck, have never invested a dime in their life, never had an account bearing much interest, and never saw any sort of 1099 in their life.

    If that is true, then their only exposure to “taxable income” is going to work each day — earned income. So to them, taxable income that isn’t earned income is a foreign (and surprising) concept to them.

  • By Liz, September 29, 2009 @ 7:46 pm

    To simplify this from the consumer’s perspective…
    You “borrow” $5000 from your credit card to pay for your Pez dispensers but only pay them back the $2000. Isn’t the other $3000 actually money the credit card company GAVE you – or – INCOME and as such, it’s taxable.

  • By sebs, March 27, 2010 @ 7:39 pm

    Let me just add a little bit of reality to these comments, since they have been absent up to now.

    If you owe a credit card company $5000 and are at the stage of having some of that debt “forgiven”, you are deep in monopoly money territory. You probably only ever borrowed from the $2000. The rest is jacked up interest, over the limit fees, late fees, fraudulent APR calculation fees, we own the government so we can do whatever we want fees, debt collection fees, and other miscellaneous crap. Instead of protection you, the government then comes back and compounds the problem by charging you taxes on “forgiven” made up debt.

  • By ck, March 9, 2011 @ 11:47 am

    Another reason is because as all good “gamers” would know, you can arb the living daylights out of this.

    Want to get around the gift tax? I will lend you 5 billion dollars. Ok, I forgive the entire debt. You just netted 5 billion, tax free.

  • By Jean, June 8, 2011 @ 4:21 am

    Agree with the last paragraph on this article.

    “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.”

    When the last time you found that tax isn’t a murky one? :D

  • By Paul Williams, June 7, 2012 @ 4:47 pm

    Sounds great in theory ck, but forgiveness of debt to a related person is considered a gift and would be subject to the gift tax.

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