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By Gerald S. Deutsch, Esq.
Glen Head, NY
Many households are suffering from burdensome credit card debt as a result of the state of our economy. So many jobs have been lost and yet people need to live, and many have no recourse but to use their credit cards. And now many can't even pay the minimum required monthly amount, and so they look to settle or restructure their debt. But do even a few ever consider the tax consequences if they do? It's so hard to comprehend that taxable income can result even if one doesn't receive cash!
So many don't understand that cancellation of indebtedness creates taxable income.1 Furthermore, the entire debt need not be cancelled. A "significant modification of a debt instrument … results in an exchange,"2 and this can result in cancellation of indebtedness income (depending on the determination of values of the debt before and after the modification under complex objective tests).
But it seems clear that a reduction of principal or interest that has accrued, which is generally the modifications sought by the debtor, will cause cancellation of indebtedness income. As the IRS points out on page 3 of Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (For Individuals), the interest portion of the forgiven debt must be included in income if the interest would not be deductible if paid by the debtor – as would be the case with most credit card debts.
There are many exceptions and relief provisions for people facing cancellation of debt income as for example those in bankruptcy,3 and those insolvent.4 But many credit card debtors do not want to go into bankruptcy and many are not insolvent. They just want a "modification" of the terms so that they can manage the debt
Congress has enacted relief for home mortgage debtors that get relief from lenders.5 And recently Congress has enacted §108(i) that permits a deferral of tax on cancellation of indebtedness income from settled business debt (and then permits that income to be reported over five years). But there is no relief for the credit card debtor that manages to reduce his burden. Why can't they be afforded the relief given business – the ability to defer the recognition of income and then spread that income over five years?
It's an awful situation for an unfortunate debtor to be in. To feel he's accomplished something worthwhile for himself and his family in being able to settle his credit card debt for a payment that now fits into his budget schedule only to receive that pesky Form 1099-C, Cancellation of Debt, some months later.
For more information, in the Tax Management Portfolios, see Maule, 501 T.M., Gross Income: Overview and Conceptual Aspects, and in Tax Practice Series, see ¶1040, Discharge of Indebtedness.
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