Debt Forgiveness and The IRS

Debt that is forgiven or written off by the lender is considered income by the IRS. The lender must issue a 1099-C tax form declaring this “income” just as though it was income from an investment. The taxpayer is liable unless they can prove that this debt was discharged in bankruptcy or that they were considered insolvent under the law at the time of the discharge. This year the IRS is projecting 6.4 million 1099-C forms will be sent to debtors for debts the creditor has written off as uncollectable or forgiven as part of a negotiated package.

This is just one more way the Great Recession has found to kick Americans who are down. Over the last three years the numbers of debtors who have defaulted on their credit card payments have increased dramatically. IRS regulations encourage companies to write off these debts within 36 months. In addition, companies have been carrying bad debt on their books for as long as 20 years. Now, as part of the general clean up of financial institutions following the crash, these companies are writing off old debts they believe are uncollectable. That means tax payers are receiving 1099-C forms for old debts, sometimes discharged in bankruptcy many years ago. They have lost the paperwork. Having no proof that they discharged this debt in bankruptcy, they are on the hook for income taxes. Not surprisingly some of these 1099-C forms contain errors that seldom favor the borrower. There have even been cases of the finance companies “double billing” the debtor for one credit card balance. In the eyes of the IRS the debtor is guilty until proven innocent. In some instances, establishing a legally valid paper trail is impossible.

The real landmine in this sad story lies just around the corner. In 2007 legislation was enacted to protect homeowners who lost their principal residence in the real estate crash. Debts discharged in foreclosure, short sales, or forgiven as part of a loan modification, would not trigger a 1099-C for additional income tax. This law is set to expire at the end of 2012. No one in Congress thought this problem would last that long. If the law is not reenacted, some Americans, who can least afford it are going to receive some very large nasty surprises. How can an unemployed worker pay the Federal Income Tax on a $150,000 foreclosure?

Most of the information found in this article comes from USA Today.