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CANCELLATION OF DEBT INCOME AND BANKRUPTCY: WHY SHOULD I BE CONCERNED?

As tax time approaches, many taxpayers are going to learn the hard way about cancellation of debt income when they file their taxes. If a creditor decides to forego the collection of a valid, undisputed debt, they may decide to cancel or “forgive” the debt. This means that the lender has decided that they will not collect the debt. In this instance, a lender who has cancelled the debt will issue a Form 1099-C to the IRS, listing the amount of debt that was cancelled. The full amount of the cancelled debt is treated as income by the IRS, and income taxes will be assessed accordingly at the appropriate tax bracket. This can generate a significant income tax liability, especially if the debt that was written off was due to the foreclosure or short sale of a former residence. For instance, if you owed $40,000 on a mortgage deficiency, and the lender decided to forgive that debt, you would be taxed on that $40,000 as if it was income. And unlike traditional wages, there are no withholdings from this “income” to soften the blow.

If you settle a debt with a creditor for less than the amount owed, you may also have cancellation of debt income. Most creditors will report the cancellation of any debt exceeding $600. If you wind up paying the taxes on the balance of such a debt, your actual amount saved may be diminished significantly. In addition, many taxpayers forget to declare the cancellation of debt income when their returns are initially filed. An amended return may have to be filed once the taxpayer is notified that their refund has been adjusted to account for the cancelled debt.

A debt that has been discharged in a bankruptcy case does not create cancellation of debt income, because the debt is not voluntary cancelled by the lender/creditor. Instead, a “discharge order” is entered which prohibits the creditor from collecting the debt. As a result, there is no “taxable event”, and the bankrupt debtor will not have to worry about being assessed taxes for the various debts that were included in their bankruptcy case. However, timing is essential, because if a creditor cancels the debt prior to a bankruptcy being filed, the debt cannot be discharged for income tax purposes. While there may be other exceptions to taxation of such income under the Internal Revenue Code, there would be no protection from the Bankruptcy Code.

Many home lenders have been pressured by the federal government to work with homeowners, and write down a certain amount of mortgage debt. Unfortunately, the unintended consequence of this pressure is that the mortgage companies will cancel debt that is already noncollectable, in an attempt to satisfy the regulatory criteria. As a result, the issuance of 1099-C forms for such debt has become more commonplace, and many tax payers are shocked when they receive their tax bill, after mistakenly believing that their liability on such a debt had been written off without any other consequences. If you believe that you may owe a significant amount of debt that is not in an active collection status, it would probably still be wise to consult a bankruptcy attorney. Most local bankruptcy attorneys offer a free consultation, and can advise you as to how a bankruptcy case may protect you from unexpected income tax liability.

 

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This article is not be to use as a reference for accounting purposes. Speak with your tax professional about how you may be affected by cancellation of debt income.

Do not confuse “charge off” with “write off”! A lender may “charge off” the debt meaning that they will no longer collect it. However, they may still assign or transfer the debt to a collection agency. On the other hand, the term “write off” generally means that nobody will collect the debt.