"Surprises Nobody Likes"

by Greg Mermel, C.P.A.

Published in the "Money and Taxes" column in PerformInk on December 19, 2008

Have you ever watched an infant confront a jack-in-the-box for the first time? The child is smiling and cooing as the built-in music box plinks out a tinny version of “Pop Goes the Weasel.” Then at the right point, the lid to the box flies open, this strange puppet figure bounces up, and – usually – the child screams. Loudly. And not with delight.

Later on, the kid may figure out that it’s fun. But the first time, he’s feeling good, and all of a sudden something unexpected and threatening appears. No wonder he cries.

I have a feeling that the same thing is going to happen to a number of financially stressed people during this next income tax season. Just when you’re feeling good about getting off rock bottom, pow – something unpleasant is in your face.

Digging Out of Debt

Let’s do a little improv. You are a fine, upstanding, middle-class American. Sensitive soul that you are, you absorbed the Zeitgeist of the past decade, so you spent. And spent. After 9/11, it even became your patriotic duty to spend. (Remember when people actually listened to what President Bush said?) You used your credit cards, too, since that let you spend far more. This was fun.

Now it’s 2008. The economy is a shambles. So are your finances. You let one credit card go past due, and – bang – all of a sudden everyone raises your interest rates high, very high. Loan sharks used to go to jail for rates like that, you thought. The low, introductory rate offers you counted on to revolve the debt stop coming. You’re stuck. You can’t make the payments. You can duck and weave for a while, not answer your phone, not open the mail, but eventually you have to do something.

So you talk to the credit card companies. This is where the improv comes in because, no matter how great your reading of “the quality of mercy is not strain’d,...” a bored high school graduate in a cubicle in a phone room in Salt Lake City isn’t going to be interested. Instead, you present your situation, reasonably, calmly. “Can we work something out?” “After all, if I have to pay the lawyers for a bankruptcy, there will be just that much less left for the creditors.”

And, lo, a miracle happens. They agree to cut your balance, in exchange for a firm payout plan on the rest.

You’re elated, even ebullient. You want to try the other miracles – Red Sea, water-into-wine, raising the dead – but decide not to push your luck. This is enough.

Then an envelope arrives from that credit card company. “Important tax document enclosed.”

Uh-oh.

In that envelope is a form 1099, but a type you have never seen before: 1099-C. “Cancellation of debt,” it says in big letters, and the amount matches the adjustment they made to your card balance. Scream about the manifest unfairness of the universe, if it makes you feel better, but it does make sense that the reduction in credit card debt gives rise to income.

Think about it. Some time in the past, that credit card issuer paid out cash. Maybe it went to you, but more likely it went to a third party at your direction. Their paying money directly to the grocery store or restaurant or big box store is economically equivalent to them giving you the money, and you then paying the grocery store or (et cetera).

When you receive money, the basic criterion for deciding whether it is income is, “do you have to pay it back?” If yes, it is not income. If no, it might be income, or it might be a gift. This debt was not income at the time you incurred it, because you had an obligation to repay. The second that obligation goes away, it becomes income. (I think we can all agree that no credit card issuer would make a gift of debt forgiveness.)

Forced Cheer

Look at it this way: negotiating with the credit card company took you at most a couple of hours, and they wrote off perhaps a few thousand dollars of debt. When have you ever been paid that much per hour? You are still ahead if you do have to pay the tax, but read on: you very well may not.

And if the debt cancellation involved a credit card, the amount is probably not over a few thousand dollars. Think about all the people who have lost homes in foreclosure. The difference between whatever sum the bank ultimately sells the house for and the amount of the mortgage will pop up as cancellation of debt. Those 1099s will bear numbers in the tens of thousands, if not hundreds of thousands. Gulp.

Skating Away

Unlike any other flavor of form 1099, the amount on a 1099-C is not necessarily income to the recipient. Frequently it is not, at least in my experience, because of two rules. One has been around for a long time, the other recent and temporary.

The permanent rule provides that the cancelled debt is not taxable to the extent the debtor is insolvent at the time of the cancellation. “Insolvent” (at least in a legal context) is not synonymous with “bankrupt.” Rather, it means that the debtor’s assets are less than his liabilities. Card issuers have no reason to settle unless they are utterly convinced the debtor cannot pay, so most people who settle are insolvent. People who still have home equity or stock portfolios need not apply.

The temporary one relates specifically to home mortgages. The amount of debt canceled in a foreclosure or short sale (where the selling price is less than the mortgage) is not taxable, provided the debt was incurred to purchase or improve your primary residence. This is one of the very few things the federal government has done to help financially-stressed homeowners in the present crisis, and it expires in 2013.

There is a catch. You can’t just ignore the 1099-C when you prepare your tax return. You have to prepare and attach a form 982, explaining why the relief is not taxable. And form 982 is not in the least user-friendly. If you find yourself needing to explain away a 2008 debt cancellation, you probably need to use a tax professional rather than doing the return yourself.

Free Offer

Every year during the income tax season, I offer free copies of my “Checklist of Potential Deductions...” for those in the arts. Just call my office, or send an email to checklist@gregmermel.com.

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