Trading credit card debt for a tax bill

Tough times are hitting the credit card industry, too,  Rather than spending a lot of time trying to collect all the unpaid balances on their books, card issuers are opting to make deals with their customers.

Or, as the New York Times notes, "As they confront unprecedented numbers of troubled customers, credit card companies are increasingly doing something they have historically scorned: settling delinquent accounts for substantially less than the amount owed."

One such beneficiary of this new attitude is Edward McClelland:

"McClelland's credit card company was calling yet again, wondering when it could expect the next installment on his delinquent account. He proposed paying half of his $5,486 balance and calling the matter even.

It's a deal, the account representative immediately said, not even bothering to check with a supervisor."

Unfortunately for McClelland, he's not likely to get such a deal from the IRS

In many (actually, most) such instances, the IRS views canceled debt as taxable income.

Homes yes, plastic no: A lot of people think that the recent changes to offer canceled debt relief to mortgage holders also absolves all forgiven debt. Not so.

McClelland will owe tax on the $2,743 he recently sent to his credit card company to wipe out that account's balance. As the story notes, he now has spared himself the prospect of years of collection calls.

But he's gained a new creditor.

McClelland's clearing of his credit card debt means that he will owe tax on the other, forgiven half that the card company ate. If he's in the 25 percent bracket, that comes roughly to $686.

Granted, a $686 tax bill is a lot more manageable than an almost $5,500 credit card bill. Still, McClelland and many others in his situation might not be aware that their deals with creditors will have tax implications.

The IRS' position. The IRS notes in one of it's many Web pages devoted to the taxability of forgiven debt, often referred to as Cancellation of Debt Income or CoDI, that:

The tax impact of debt forgiveness or cancellation depends on your individual facts and circumstances. Generally, if you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the canceled amount in income for tax purposes. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

Elsewhere, the IRS offers some ways to get around having to count the canceled debt as income. Most of them, however, are not that palatable:

If you had a nonbusiness credit card debt canceled, you may be able to exclude the canceled debt from income if the cancellation occurred in a title 11 bankruptcy case, if you were insolvent immediately before the cancellation, or if you were affected by the Midwestern disasters. You should read Bankruptcy, Insolvency, or Qualified Midwestern Disaster Area Indebtedness under Exclusions in Chapter 1 to see if you can exclude the canceled debt from income under one of those provisions. If you can exclude part or all of the canceled debt from income, you should also read Bankruptcy, Insolvency, and Qualified Midwestern Disaster Area Indebtedness under Reduction of Tax Attributes in Chapter 1.

Yep, if you file for bankruptcy, the IRS also will usually forgive your canceled debt. How thoughtful.

Other CoDI relief: The financial difficulties related to last year's major Midwestern storms are a one-time deal, but other, more long-term instances in which canceled debt is erased from IRS taxable income ledgers include:

• Bankruptcy, mentioned previously;
• Insolvency, which means basically that your total debts are more than the fair market value of your total assets;
• Certain farm debts;
• Non-recourse loans, which are loans for which the lender cannot pursue you personally in case of default; and
• Forgiveness of Qualified Principal Residence Indebtedness.

Each of these debt forgiveness circumstances is detailed in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.

Home debt special rules: As mentioned several times earlier, forgiveness of a debt connected to your primary residence is excluded from taxable income.

This is thanks to the Mortgage Debt Forgiveness Act of 2007. Since its passage, the tax relief for folks facing foreclosure or loan restructuring has been expanded.

The latest change in this area came in the Emergency Economic Stabilization Act, the bailout bill enacted in October 2008. Now, mortgage loan debt canceled in 2007 through 2012 is not taxed.

In all cases of canceled debt, your lender or creditor should send you a Form 1099-C, Cancellation of Debt, showing any forgiven debt.

Homeowners eligible to count that amount as nontaxable will need to report the canceled mortgage debt on Form 982 and send it in with your personal tax return.

But those of you with debt canceled in connection with a credit card or other loans, will need to note that amount on the "other income" line of your tax return.

You're not alone: Don't feel bad if you're confused by all the debt cancellation tax issues. You are definitely not alone.

In fact, the topic made National Taxpayer Advocate Nina Olson's latest list of "The Most Serious Problems Encountered by Taxpayers."

In her 2008 annual report to Congress, issued earlier this year, Olson notes that:

When a creditor writes off a debt, the tax code generally treats the amount of the canceled debt as taxable income to the debtor, but Congress has carved out a number of exceptions. The rules that determine whether cancellation of debt income is includible in gross income are complex, and taxpayers often do not receive reliable information about their tax reporting and payment obligations.

To help make things easier for affected taxpayers, Olson recommends that the IRS take several steps to address this problem, including developing an insolvency worksheet that taxpayers can file with their returns and creating a centralized unit dedicated to handling cancellation of debt issues.

Given the other things that folks in Washington have on their plates right now, I doubt that any action on canceled debt is imminent. But at least the matter has been raised, and I suspect it will continue to make the Taxpayer Advocate's future taxpayer top trouble lists.