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Debt Cancelled, But How Much Will It Cost Me?

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It’s a truism of the U.S. tax code that a simple question usually begets a complicated answer. That’s certainly the case for Sylvia, a Credit.com reader with a simple question about an increasingly common situation.

“My credit card company just sent me a letter that they will charge off. . . or they will forgive $12,000 of my $30,000 debt,” a reader using the screen name “Sylvia” writes in response to a recent Credit.com story. “What is the tax on this?”

Here’s the simplest answer: That depends. Here’s why. When lenders forgive debts, the IRS treats the forgiven principal as income. That would trigger a 1099-C. In Sylvia’s case, then, the amount she’s taxed overall may depend on the sum of this equation: (Her current income) + ($12,000).

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Maybe her tax rate will stay the same. If that extra $12k is enough to place her into a higher tax bracket, then she’ll have to pay taxes at that new, higher rate. To get an estimate of how she’ll fare, Sylvia can check this summary of tax brackets.

“It’s treated as regular income,” says Gerri Detweiler, Credit.com’s consumer credit expert, who has written many stories about the 1099-C. “It could potentially bump her up to a higher tax bracket.”

Free Credit Check & MonitoringHowever, the answer is more complex than that. There is a way that Sylvia could potentially reduce the amount she has to pay as a result of a 1099-C. It’s called an insolvency exclusion. Here’s how it works. If Sylvia’s debts exceed her assets, she can apply for an insolvency exclusion. If debts exceed assets by more than $12,000, then the entire 1099-C amount can be excluded from her income (and, therefore, her taxes).

If her debts exceed her assets by, say, $5,000, then that amount would be subtracted from the 1099-C total, meaning that only $7,000 of the forgiven credit card debt would count as additional income. To figure this out, “she should talk to a tax advisor,” Detweiler says.

After that, there’s still one more kink to figure out, Detweiler says. In her email, Sylvia says her credit card issuer has offered to “charge off” or “forgive” $12,000 worth of debt. Those might sound like the same thing, but actually they’re not. A charge-off describes an accounting maneuver in the lender’s financial books in which the bank essentially says, “We have to write this off as a bad debt,” says Detweiler.

But the company can still try to collect just in case. Or it can sell the debt to a debt collection company. Either way, the bad news for Sylvia is that the debt would still exist, and she still could be sued for it. So while the debt does not go away with a charge off, the good news is that Sylvia would not owe taxes on it.

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“A charge off doesn’t doesn’t trigger a 1099-C,” Detweiler says.

If $12,000 worth of debt is forgiven, however, that means it goes away entirely, and the bank or private debt collectors have no way to try to collect it later. In this case, as long as the bank hasn’t tried to collect the money in the last three years, it is required to send a 1099-C form informing the IRS of the forgiven debt (and potentially incurring a bigger tax bill for Sylvia).

Check out Detweiler’s other stories that delve into the intricacies of the 1099-C:

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Image: TaxBrackets.org

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  • http://www.springcoin.com/blog Kevin @ SpringCoin

    Well said Chris, if anyone is actually in this dilemma, definitely talk to your accountant. For more information, you can also look here:

    http://www.irs.gov/pub/irs-pdf/p4681.pdf

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