Canceled debt often must be reported as income

WASHINGTON – March 7, 2011 – One can only imagine all the high-fives and fist-bumps that erupt once a can’t-make-ends-meet borrower finally, finally talks a lender into forgiving $3,000 in credit card debt.

Now let’s picture that same person months later handing over a little piece of paper called a 1099-C to a tax preparer.

The tax preparer must break the bad news: Most times, canceled debt is treated like income. And $3,000 of forgiven credit card debt must be reported as income on state and federal income tax returns.

“Sort of what you did is you switched creditors,” said George W. Smith IV, a certified public accountant and partner at George W. Smith & Co. in Southfield, Mich.

“I had one guy storm out of here saying, ‘I’m not going to report it,’” Smith said.

If you don’t report it, you can expect the Internal Revenue Service to come calling.

“The IRS gets a copy of that 1099,” said Jim Van Grevenhof, senior tax analyst for the tax and accounting business of Thomson Reuters. “They’re going to be looking for that on your tax return. And if you don’t deal with that, they’re going to ask why.”

A Form 1099-C is issued when a debt of $600 or more is forgiven or canceled. According to the IRS, the number of 1099-C forms filed with the federal government by creditors and debt collectors grew from fewer than 1 million forms in 2003 to more than 1.987 million in 2008. Some estimates project 2.8 million 1099-C forms will be sent out in 2011 for the 2010 tax year, according to CreditCards.com.

What’s unsettling, of course, is that people who couldn’t afford to pay their debt now owe thousands in taxes.

“It’s very unlikely they have several thousand dollars sitting in the bank that they can use to make an unexpected tax payment,” said Ben Woolsey, director of marketing and consumer research for CreditCards.com.

They’re going to need to borrow money – or enter into installment payment plans with the IRS.

“We’ve seen this issue more frequently in the past several years, both with credit card debt and home mortgages,” said Marshall Hunt, certified public accountant and director of the tax-assistance program of the Accounting Aid Society in Detroit. If you’d need to add $50,000 in canceled debt to your income, you could be looking at another $15,000 owed on a tax bill.

All canceled or forgiven debt, though, is not treated the same.

For example, if student loan debt is canceled as part of a forgiveness program for working in a particular field, such as health care in an underserved community, the debt that is forgiven is tax-free. The same is true for public service loan forgiveness programs, said Mark Kantrowitz, publisher of Fastweb.com and author of “Secrets to Winning a Scholarship.”

But the forgiveness of the remaining student loan balance after 25 years in an income-based repayment program is taxable.

Given the complex rules, you should provide the 1099-C to the tax preparer.

There is a special provision that allows up to $2 million of canceled debt on a mortgage to be excluded from income. This applies only to a principal residence – not a second home. And the exclusion applies only if a foreclosure or short sale takes place from 2007 through 2012.

The canceled debt must have been incurred to buy, build or improve your main home.

Consider this example from Van Grevenhof: Say a couple paid $500,000 for their home. But the house’s value tumbled to $350,000 after the collapse of the housing market. Their mortgage was for $450,000. One person lost a job and the couple couldn’t afford the monthly mortgage. They handed the deed to the bank and walked away.

The bank sold the house for $350,000. The house sold at a $150,000 loss, and the couple had $100,000 in canceled debt.

The loss is not deductible. But that $100,000 in income now is covered by the “Principal Indebtedness Exclusion.” So this foreclosure does not drive up their tax bill.

Who faces the most headaches?

Watch out if you tapped into the equity of the house to make an investment in a sure bet, but later lost your shirt and walked away from that debt.

“You had a buddy who said ‘I’ve got a great deal for you’ – and you put it in a Ponzi scheme,” Smith said.

You could end up with an extra $50,000 showing up as income on your tax return.

And if you faced foreclosure on your vacation property, you would have to report that forgiven debt and would owe taxes on it.

“All of a sudden, I’m saying ‘Guess what? Here’s your tax problem,’ “ Smith said.

What you should know

If you had debt forgiven, here’s what you need to know at tax time:

• A 1099-C is sent to the borrower and the IRS if a creditor or debt collector agrees to forgive $600 or more in debt.

• You would want to look at Box 2 of Form 1099-C for the amount to be reported as “other income” on Form 1040.

• Make sure to dig deep into your mail to find all Form 1099-Cs that you would receive from a federal government agency, credit union or bank.

• Complex rules exist for mortgages and some student loan debt. You need to know rules about when forgiven or canceled debt can be excluded from income. For example, a special exclusion exists for health care professionals who have student loans forgiven and they work in underserved communities.

• Other exclusions apply, too. For example, cancellation of debt income that occurs during bankruptcy proceedings is excluded from income, as is cancellation of debt income to the extent of the borrower’s insolvency immediately before the debt forgiveness event occurs. Also, there is no cancellation of debt income if the mortgage was nonrecourse or seller financed.

Courtesy of: Detroit Free Press, Susan Tompor. Distributed by McClatchy-Tribune Information Services.