By Connie?Prater
If you thought your money woes ended last year when you settled that credit card debt, think again.
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| AVOIDING 1099-C TAX PROBLEMS |
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What you should know: Have you settled a debt with a creditor by paying less than you owe on a credit card debt? Congratulations on putting it behind you, but here's the bad news: The IRS considers forgiven or canceled debt as taxable income. You probably have to report it and pay taxes on it. |
For many consumers with debt problems, after the debt collector leaves their lives, the taxman arrives.
Months after successfully resolving credit card debts, consumers may receive 1099-C "cancellation of debt" tax notices in the mail. Why? The U.S. Internal Revenue Service considers forgiven or canceled debt as income. Creditors and debt collectors who agree to accept at least $600 less than the original balance are required by law to file 1099-C forms with the IRS and to send debtors notices as well. Taxpayers must report that portion of forgiven debt as "income" on their federal income tax returns.
"A lot of people don't realize they have any tax issues at all when they are going through this," says Alison Flores, a researcher at The Tax Institute at H&R Block, the nation's largest tax preparation service. "They say 'I'm really poor, I'm broke and I can't pay my bills. How can you consider this income?'"
It is, according to the Internal Revenue Code. For example, a person with $10,000 in credit card debt who negotiates to pay only $6,000 of the balance would have $4,000 in forgiven debt income. That $4,000 must be reported as "other income" on Line 21 of the 1040 tax form. Depending on the amount of debt forgiven, the taxpayer's income level, deductions and other factors, the consumer could face a sizable tax bill come mid-April.
Surprise tax problem
The problem: Many consumers have no clue what the 1099-C forms are, and some may be trashing the cancellation of debt notices because the forms are sent by creditors or debt collectors with whom they thought they no longer had business. Still others are not filing the 1099-Cs with their federal income tax returns -- putting taxpayers at risk for IRS audits, penalties and fines. Consumer credit counselors and tax attorneys say few consumers are aware of the tax implications of settling to pay a lesser amount than they owe in credit card debt.
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Just when they think the debt monkey is off their back, here comes the IRS obligation. |
| -- Gail Cunningham? National Foundation for Credit Counseling? |
"It's truly something that consumers need to be aware of, as they are often blindsided by it," says Gail Cunningham, spokeswoman for the National Foundation for Credit Counseling, a nationwide group of nonprofit credit counseling agencies. "Just when they think the debt monkey is off their back, here comes the IRS obligation."
The number of "surprise" tax problems grew as the amount of bad debt rose during the recession, and has lingered since.
According to the IRS, the number of 1099-C cancellation of debt forms filed with the federal government by creditors and debt collectors more than tripled?between 2003 and 2010 -- the most recent year with firm figures. Most of the increase took place during the recession. The IRS received fewer than 1 million forms in the calendar year 2003 and more than 3.9 million in 2010. The projected number for?2012 was 6.4 million (see chart), and the IRS expects to get 6.5 million debt forgiveness forms in 2013.
A 2008 study by the National Taxpayer Advocate Service, a consumer branch of the IRS, found that credit card debt accounted for 47 percent of the 1099-Cs reviewed in a random sample of tax returns. Mortgage-related debt was only 15 percent of the sample. That was before the home foreclosure crisis and the proportion of mortgage-related debt forgiveness has likely increased, but a significant portion of it is still attributed to credit card debt.?
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| Debt forgiveness leads to rise in 1099-C filings |
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Canceled and forgiven debt may be taxable income for some consumers. According to the IRS, the number of taxpayers filing debt cancellation forms more than tripled?between 2003 and 2010. The IRS estimates the volume of filings?will continue to climb into 2015, when they will hit a projected 6.7 million. |
Mark Steber, chief tax officer for the Jackson Hewitt tax preparation service, says his preparers have noticed an uptick in clients coming to them with 1099-C notices. "What we're seeing is credit card companies and credit agencies are being more liberal. We're seeing more forgiveness of debt," Steber says.
Negotiating with creditors, debt collectors and debt buyers to pay a fraction of the amount owed is a common practice in the industry, often accomplished through third-party agents such as consumer credit counselors or debt settlement specialists.
"Debt buyers are willing to negotiate a discount, sometimes at a very significant discount off the entire balance, to settle the debt," says Barbara Sinsley, general counsel for the 600-member Debt Buyers Association (DBA International), a trade group of companies that buy and sell portfolios of debt from banks and other creditors.
Not all forgiven debt taxable
Consumers who receive the 1099-C cancellation of debt forms should immediately take them to a tax preparer or tax adviser, experts say.
"Make sure your tax preparer understands the rules related to these type of activities," says Steber. "Ask to talk to an office manager. Tell them 'I need to see someone who understands this type of situation.'"
Taxpayers may qualify for one of several exclusions that allow them to reduce taxable income from canceled debts. If the exclusions apply, they must file an IRS form 982 in addition to the 1099-C.
"Theoretically, you have income [that can be taxed] if you don't meet one of the exceptions," says Eric L. Green, a tax attorney with the Convicer & Percy law firm in Glastonbury, Conn.
The exclusions include debts discharged during bankruptcy and debts of consumers who are insolvent (meaning their liabilities exceed their assets) prior to the cancellation of debt. However, the exclusion applies only up to the amount by which consumers are insolvent. That means if $5,000 in debts were forgiven and liabilities exceeded assets by $2,000, then the $2,000 would be excluded as income. "The remaining $3,000 would be reported under other income," says H&R Block's Flores.
| DEBT RESOLUTION TAX TIPS |
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Homeowners exclusion extended
Homeowners who default on mortgage loans on their primary residences may also qualify for an exclusion from income on foreclosures under the Mortgage Forgiveness Debt Relief Act, which took effect Dec. 20, 2007, to help homeowners caught in the mortgage crisis. This provision applies to up to $2 million in mortgage debt forgiven in calendar years 2007 through 2013. Taxes filed by the April 2014 deadline will be the last opportunity to claim the mortgage debt forgiveness exemption. This exception had been scheduled to expire at the end of 2012, but Congress extended it by a year as part of the "fiscal cliff" negotiations.
Steven M. Piascik, a certified public accountant and president of Piascik & Associates in Virginia, says, "If you use the proceeds from a home equity line of credit to pay off credit card debts, or for something other than making improvements to your home, that portion will not qualify for the $2 million exception."
If you used a credit card to pay for home improvements on your primary residence and can prove that the charges were exclusively for home improvements, you may be able to claim an exemption from mortgage-related debt forgiveness income for that card debt.
Informing consumers
Much of the surprise element of the 1099-C cancellation of debt forms could be eliminated, say tax preparers, if all creditors and debt buyers routinely informed consumers that there could be tax ramifications when settling debts for discounted amounts.
At Wells Fargo, one of the nation's five largest credit card issuers, all settlement-offer letters include disclosure of possible 1099-C implications, according to Lisa B. Westermann, assistant vice president of public relations for Wells Fargo Card Services. Other credit card issuers did not respond to requests for information about their policies.
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| Credit card, mortgage delinquency coincide with boom in 1099-Cs |
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Getting overwhelmed by debt from credit cards home loans became more common during the recession, and when that debt became impossible to pay, banks eventually charged off or wrote off the debts. That, in turn, helped cause a spike in 1099-C income tax notices. The chart shows the ratio of dollars written off compared to the amount of dollars loaned for credit cards and residential real estate loans. |
"The bank doesn't tell you," says Green, the Connecticut tax attorney. "From the bank's perspective, it's not their job to give tax advice."
Says Sinsley from the debt buyers group: "There is no current law that says that a debt buyer must disclose that a 1099-C would be forthcoming after the settlement of debt."
She says debt buyers have been sued for the unlicensed practice of law after giving consumers advice on resolving their debts. It's something she advises her members to avoid. "A debt buyer is not the consumer's financial planner," she says. "Everybody's financial situation should be discussed with a tax adviser."
Knowing the amount of forgiven debt to be reported to the IRS would help consumers plan ahead, Sinsley says. "When they are negotiating the settlement of the debt, the consumer can discuss with their tax adviser what consequences there would be in exchange for the settlement of the debt," she says. "If the consumer is settling a debt, and they know the settlement is X and the forgiveness is Y, they can go to their tax preparer and say, 'If I do this, what is my tax impact?'"
The National Taxpayer Advocate Service has cited confusion and inadequate communication about 1099-Cs in its annual report to Congress on IRS improvements needed to help consumers. The IRS held a forum on understanding the tax consequences of canceled debt in 2009 to help clear up some of the confusion. The taxpayer advocate's office has also published YouTube videos in an effort to demystify the 982 tax forms needed to claim an exemption from taxes on forgiven debt.
Check the figuresAnother tip from tax preparers: Make sure that the amount of canceled debt listed on the 1099-C form is accurate.
"If you get a 1099-C, make sure that you understand what that number represents," says Steber from Jackson Hewitt. Consumers may find the amount of forgiven debt on the tax notice much higher than they expected. "There's a sticker shock element," Steber says.
"They forgave $8,000 of my debt, but the 1099-C says $20,000. It's not simply the debt; it's the debt plus all the other things. They pay people to go and manage this [debt collection] to a degree and it costs money and sometimes a great deal of money to draw to conclusion and that's all included."
Steber adds, if there is a discrepancy, "you better go back and talk to them now and find out what it is."?
Another potential problem: receiving a 1099-C before the debt is actually paid off. According to Lauren Saunders, managing attorney for the National Consumer Law Center, creditors have sent cancellation of debt forms to consumers at the point that the credit card issuers charged off the debt and sold it to debt buyers. "The consumer is potentially liable both for taxes on supposedly forgiven debt while continuing to be liable for the debt," Saunders says. "We've had calls about that situation. Seems like you can't have it both ways: Either you forgive it or sell it but not both."
The federal taxpayer advocacy agency cited the gap in creditor reporting requirements as one of the most serious IRS consumer problems in its 2010 report to Congress. "A creditor that issues a Form 1099-C is not necessarily canceling a debt, yet the IRS assumes that Form 1099-C reflects taxable income to the debtor," according to the report. The taxpayer advocate recommended that the IRS revise the 1099-C form to include a box for creditors to indicate whether a debt was actually canceled. The IRS responded that it would consult its legal advisers.?
Several tax advisers called the 1099-C requirements unfair to consumers trying to overcome mountains of debt. Others say the tax rule is further proof that there is no free ride and consumers who borrow money must be prepared to live up to their financial obligations.
'Be aware of it and prepare for it'
The bottom line on 1099-Cs, says tax attorney Green: "Be aware and prepare for it. When you receive that form, go immediately to a tax adviser. Don't ignore it. That has real dollars and cents consequences."
Steber, from Jackson Hewitt, warns that the IRS is more advanced at tracking taxpayers' income. "There is an increased likelihood that if you had one of these events that the IRS knows about it," he says. "The IRS tracks it back. The IRS is quick to catch up with the person who, for whatever reason, left that [1099-C] off of their return."
Taxpayers who might have moved and didn't receive their 1099-C notices in the mail from creditors can't count on ignorance as a defense: "They will catch up with you," Steber says.
See related:? 6 exceptions to paying tax on forgiven debt, Canceled debt exemption little used,?Canceled debt tax notices riddled with problems
Updated: January 10, 2013
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