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Archive for Tuesday, August 15, 2006

Canceled debt can cause tax bill

August 15, 2006

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If you're working with a creditor to forgive some of your debt, there's something important you should know.

Any debt that is canceled could create another bill - a tax bill.

"I am a tax preparer with a very large tax preparation company and have had to deal with unhappy taxpayers who are upset to find they have a tax liability they did not expect," said Larry Cohen, a senior tax adviser at an H&R Block office in Wheaton, Md.

Cohen's remarks were prompted by a recent column I wrote about whether debtors should accept a settlement. That column was the first of several on the issue of debt collection. This second installment deals with an important downside of debt dealing.

Cohen remembers one client he tried to help after her consulting business failed. The woman had been living on her credit cards and eventually amassed about $30,000 in debt. She was able to negotiate that debt down to about $10,000, Cohen said.

But the cancellation of debt created a $5,000 federal tax bill.

"When I told her she would have to pay taxes on the $20,000 that was forgiven she was absolutely flabbergasted," Cohen said. "She was just completely upset. She just ran out of the office. She didn't even pay me."

Cohen and other experts say borrowers often aren't aware of the tax implications of debt cancellation, which also can trigger a state tax debt.

If some of your debt is forgiven as a result of a car repossession or renegotiated credit card or mortgage debt (often the result of a foreclosure), you should receive IRS Form 1099-C "Cancellation of Debt" or 1099-A "Acquisition or Abandonment of Secured Property."

Only certain institutions are required to send borrowers a 1099 if debt is forgiven. They include federal government agencies, certain agencies connected to the federal government, financial institutions, finance companies or credit unions. The agency or institution is supposed to send a 1099 if the canceled debt is more than $600.

However, other creditors can and do voluntarily submit the forms to the IRS.

And no, the tax obligation doesn't go away if the creditor fails to send you the form at the end of the tax year. Although you didn't get a 1099, it's possible the creditor sent one to the IRS. The settled debt should be reported on your 1040 tax form.

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