Cancellation (and Collection) of Debts at the Same Time?

It boggles my mind that banks and other creditors can still collect on debts that they have “cancelled” for tax purposes. You might not know about the “cancellation of debt”, but you can read here about what the IRS says about it. First, I need to explain what this whole concept in tax law actually is.

Basically, let’s say that you default on a loan or credit card account which has a $10,000 balance. The bank can issue a Form 1099-C to you for the amount that it “cancelled”. Moreover (and the debt settlement companies never tell you this one), if you “settle” that same account for $4,000, then you may receive a 1099-C for the $6,000 amount that’s been forgiven.

So, you’ll have to pay income tax on that $6,000 settled debt or the entire $10,000 defaulted debt, whichever was your outcome. Remember that according to the Internal Revenue Code, the IRS will consider that money to be taxable income to you.

Okay, back to me being mindboggled: it absolutely disturbs me to find out that most courts around the country have followed several IRS information letters which state that if a creditor issues a Form 1099-C, the delivery of the Form to the borrower does not constitute a bar to collections activity. Basically, the creditor can still sue the borrower even though they’ve cancelled the debt for tax purposes.

Finally, a sane Court has realized the unfairness of this concept. Judge Richard Stair, Jr. held in the recent case of In re Reed, in the U.S. Bankruptcy Court of the Eastern District of Tennessee, that when First Tennessee Bank issued a Form 1099-C to the debtor, the issuance of the Form reflected the discharge or cancellation of the debt. Specifically, the Judge stated that the principal amount that was listed on the Form 1099-C was cancelled, but that there may have been other fees, such as interest and collection costs that might be still owed.

One big tax advantage for those who file bankruptcy is the ability to short-circuit the Form 1099-C process. Indeed, those who have claimed either insolvency or bankruptcy are able to seek exemptions from the 1099-C tax liability by attaching Form 982 to their individual tax returns.

And, who knows, maybe other courts around the country will adopt the equitable outcome in the Reed case.

One final and related note: it remains to be seen whether Congress will extend the Mortgage Forgiveness Debt Relief Act which expires at the end of 2013. This law was passed to provide relief for those who had lost their homes in foreclosure, so that those borrowers could exclude from their income any cancelled debts that may have arisen from their foreclosed residences.

Again, beginning in 2014, a bankruptcy filing for someone who is losing their home in foreclosure might turn out to be an even better income tax decision.

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