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Phantom ‘income’ from forgiven debt leads to real tax bill

Fred Williams

If a lender forgives a debt over $600, you probably owe income taxes on it. To the IRS, a loan that you don’t have to pay back counts as income. That sounds fair — until you take a closer look at some of the so-called income that can land on your tax return.

Say you are unable to make payments on a $5,000 credit card balance. The card issuer will probably wait six months before charging it off as a bad debt. In that time, late fees (at $30 a month) and penalty interest (at 25 percent APR) will add about $1,110 to your balance.

Phantom income from forgiven debt leads to real tax bill

Then you negotiate a settlement that erases the debt, turning it into income for you. Is that $1,110 really the same as income in your pocket? “No!” your pocket says, “I never saw a dime of it.” But the tax code disagrees.

“When you set up the credit card account, you agreed to pay fees and interest,” explained Alison Flores, principal tax research analyst at H&R Block. When the bank writes off money you owed, that’s income, at least in the eyes of the tax collector. The creditor is supposed to send you — and the IRS — a 1099-C form showing the amount of forgiven debt.

“The IRS works on data matching,” Flores said. “If they get a copy of a 1099-C they’ll look for that income on your tax return — as far as the IRS is concerned, that’s what they know.”

Eric Green, a tax lawyer in Connecticut, agreed. He had a client who tried to fight the presumption that written-off debt is the same as income. The client didn’t get very far.

“The IRS examiner took the position that, ‘all we know is, it is a debt you owed, you contractually agreed to pay it,’ ” he said.

Green and Flores both said they’re seeing lots of taxpayers these days with 1099-C forms showing forgiven debt. “Virtually every financial firm does that now because they want to take the write-off,” Green said. “They’re handing these out like they’re going out of style.”

People expected the flurry of 1099-Cs to die down as the foreclosure crisis cleared up, Flores said, “but we’re still seeing quite a large number.” After a lender forecloses on a home, the former owner may owe taxes on the part of the mortgage that was not paid off by the lender’s sale of the property. Fortunately for homeowners, Congress extended relief from taxes on that phantom income through tax year 2014. But nonhousing debt doesn’t qualify for a break.

James Coll, owner of a carpet cleaning business in Pennsylvania, ran into the forgiven debt issue after he stopped making payments on an auto loan. He owed several thousand dollars on his van, which was eventually forgiven by the bank. He got a $3,800 tax bill from the IRS — even though the repo man had towed the van back to the dealer. Coll didn’t get to keep the van, but the bank’s loss on the loan still boosted his taxes.

“I owed $9,500 on the van so the IRS said that was income for me,” Coll wrote on an online message board at CreditCards.com.

What is a cash-strapped taxpayer do? While there’s little hope of getting phantom income erased from your tax bill, there are other breaks. Debt discharged in bankruptcy is exempt from the tax, for example. And if you can show you were insolvent when the debt was forgiven — meaning your debts outweighed your assets — you can reduce the amount of your forgiven debt income. The reduction you can take is equal to the amount of your insolvency — the amount by which debts exceeded assets.

“That helps a lot of people,” Flores said.

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