Feature Articles: Taxes
Debt forgiveness a taxing situation
Story source: Andrew Zumwalt, M.S., Associate State Specialist, Personal Financial Planning, University of Missouri Extension; Media contact: Debbie Johnson, Senior Writer, University of Missouri Cooperative Media Group
The struggling economy has been rough on everyone. For middle- to low-income families who have used credit cards as a lifeline, the economic woes are even tougher. Many under- or unemployed consumers who carry massive credit card debt are taking advantage of debt forgiveness options with creditors and debt buyers.
While this may be much-needed relief, debt forgiveness does not come without a price.
“What a lot of people don’t realize is that when you have debt canceled, it’s almost as if someone gave you the income to cancel the debt,” said Andrew Zumwalt, family financial specialist for University of Missouri Extension.
Like other kinds of income, debt cancellation is taxed.
Many who breathe a sigh of relief because debt collectors have been kept at bay are shocked when Form 1099-C, Cancellation of Debt, arrives in the mail. Recipients will suddenly realize that they have traded one financial burden for a smaller but still substantial obligation.
“For example, if you owed $10,000 and the credit card company forgave $5,000, the creditor is going to take a loss of $5,000 off their taxes,” Zumwalt said. “If they get to take it off their taxes, then somebody else has to take on those taxes. So people who get debt forgiven have to pay the income tax.”
This surprise tax responsibility isn’t a small problem. The Internal Revenue Service expects more than 6 million 1099-Cs for 2012.
The tax burden isn’t the only price you’ll pay. You will also get a less-than-glowing notation on your credit report.
“It will show that you couldn’t pay the full amount of your debt, and that’s going to be with you for at least seven years,” Zumwalt said. “Creditors want to know — can you pay back your full balance? And if you didn’t, it’s a black mark on your credit status.”
Lack of communication is at the core of this growing problem, he said. Too many creditors and debt buyers fail to explain the tax ramification of debt forgiveness. In a 2008 report to Congress, the IRS Taxpayer Advocate Service cited confusion and inadequate communication about 1099-Cs as an issue the IRS needs to address to help consumers.
If you have negotiated the cancellation of debt and receive a 1099-C, it’s best to seek professional advice from a tax preparer who understands the rules related to debt forgiveness. For example, there are several exclusions, including bankruptcy, insolvency, or real property indebtedness, that could reduce the amount of taxable income incurred from debt negotiations.
For accompanying audio and video clips for this article, go to http://extension.missouri.edu/news/DisplayStory.aspx?N=1356
For more information:
- Tax Consequences of Canceled Debt – IRS presentation: www.irsvideos.gov/CanceledDebt
- IRS Taxpayer Advocate Service video on exclusions for debt forgiveness: http://www.youtube.com/watch?v=qdpwtaSGpfQ
Last update: Monday, April 09, 2012