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This tax season, there’s good news for people struggling with debt. Under a new IRS rule, people will no longer be squeezed for taxes just because an old debt has gone unpaid.
Before coming to that, however, some bad news: Borrowers still owe taxes on extinguished, canceled or “forgiven” debt. The classic case of forgiven debt is when a taxpayer settles a debt by paying less than the full amount due. For example, if you settle a $3,000 credit card balance by agreeing to pay half, you’ll owe taxes on $1,500 of “forgiven” debt. (That’s unless you are bankrupt or meet another exemption.)
The number of forgiven debt filings, called “1099-C” forms, has soared since the Great Recession as creditors wrote off bad debt. Lenders “want to get the tax write-off,” said Eric Green, a tax attorney in Connecticut. Creditors report a debt as extinguished so they can claim it as a loss on their own taxes.
For consumers in a tough spot financially, the tax bill on forgiven debt is a bitter pill. Usually, the debt is only partly made up of money they actually borrowed and spent. “Banks won’t tell you how much of it is fees,” says accountant Gary Bode. “And frankly a lot of it is fees – they can really jack that up.”
Nevertheless, the unpaid fees and interest count as income, for tax purposes, even though it never went into your pocket.
And it gets worse. Many people received notices of forgiven debt for loans that had not been forgiven at all – they were just old. Under a controversial IRS rule, creditors were supposed to send 1099-C forms for debts that had gone without any repayment for a 36-month period. The theory was, these debts were unlikely to be repaid.
“The danger here is, if there is any room for a creditor to continue normal collection activity after issuing a 1099-C, that really puts people at risk,” said Bruce McClary, vice president of communications for the National Foundation for Credit Counseling.
In fact, the 36-month rule did cause people to get dunned for debts that were not extinguished, the Taxpayer Advocate Service said in a report to Congress. The service, an office within the IRS, cited the practice as a top problem for taxpayers. Debt collectors could even use the 1099-C form as leverage against debtors, the report said.
“Creditors may threaten to ‘sic’ the U.S. government’ on a debtor by issuing a Form 1099-C as a means of pressuring a debtor to pay,” the advocate’s report said.
This is where the good news comes in: The IRS has dropped the 36-month rule. This tax season, creditors should not send you a 1099-C form unless the debt is really canceled, extinguished, forgiven, and gone for good.
Not everyone has read the memo, however. The rule change, effective immediately, was published in the Federal Register Nov. 10, 2016. It was subsequently announced in Internal Revenue Bulletin 2016-48 on Nov. 28. But not all the tax lawyers I spoke to this week had heard of the change. Chances are that some creditors are not on board yet either.
So this tax season, taxpayers with unpaid debts in their past still need to be vigilant about unforgiven debt. Fortunately, now the IRS is on their side. If a 1099-C arrives for which you did not explicitly settle the debt, contact the creditor and get clarification. If they cite the 36-month rule, refer them to IRS Bulletin 2016-48, “Removal of the 36-month nonpayment Testing Period Rule.”
If the creditor does not confirm that the debt is forgiven, they should rescind the 1099-C. If they don’t, you’ll need to use the IRS dispute process. “That’s pretty involved,” McClary said, and includes attaching a written statement to the tax return. It may require the help of a tax professional.
But it’s worth it not to pay income taxes on a debt that’s still hanging over your head.
See related: 1099-C form brings surprise: IRS taxes forgiven debt