Credit card debt triggers tax problems – know your options

Did you know that forgiven credit card debt triggered taxable income

Mike Habib, EA

A new Tax Court case illustrates how a taxpayer generally has taxable income when a credit card company agrees to accept a reduced payment in settlement of his or her account.

Background. A solvent debtor usually realizes income from the discharge of a debt. (Code Sec. 61(a)(12)) Debtors who are insolvent, in bankruptcy, or (in certain cases) farmers and noncorporate debtors whose debt is qualified real property business indebtedness do not recognize income on a cancellation of a debt. (Code Sec. 108(a)) Instead, they must reduce their loss or tax credit carryovers or the basis in their assets. (Code Sec. 108(b)) These reductions can cause the debtor’s taxes to increase in future years.

In addition, cancellations of up to $2 million of mortgage debt on an individual taxpayer’s main home in 2007 through 2009 are excluded from income, but the taxpayer’s basis in the home must be reduced. (Code Sec. 108(a)(1)(E), Code Sec. 108(h))

The amount of COD income where indebtedness from a credit card account is discharged is the difference between the entire amount due on the accountand the amount paid for the discharge. If no consideration is paid for the discharge, the amount of COD income is equal to the entire amount due on the account.

Code Sec. 108(e)(5) provides an exception to Code Sec. 61(a)(12) where the buyer of property negotiates with the seller/creditor for a discharge of all or part of the purchase money indebtedness. Commonly such a discharge reflects a decline in the value of the property. The resulting discharge of indebtedness is characterized not as taxable income but in effect as a retroactive reduction of the purchase price.

Facts. Ancil Payne used his credit card with MBNA America Bank to pay hospital bills and receive cash advances during periods of unemployment. By Apr. 26, 2004, he accumulated $21,407 of debt on the card. Later in 2004, Mr. Payne and MBNA entered into an agreement whereby MBNA agreed to accept $4,592 as a full settlement of the account balance of $21,270, payable in installments over 4 months. Mr. Payne made the necessary payments, and MBNA issued him a Form 1099-C, Cancellation of Debt, reporting $16,678 of discharge of debt income.

On his 2004 joint return, he and his wife did not report any debt discharge income. Instead, they attached a statement to their return which disclosed that they received a Form 1099-C from MBNA that reported discharge of debt income of $16,678. The statement also explained that they believed the amount disclosed on the Form 1099-C was not subject to income tax.

IRS determined a deficiency for the Paynes’ failure to report debt discharge income. The couple petitioned the Tax Court for a redetermination of the deficiency.

Failed argument. Before the Tax Court, the Paynes contended that their settlement with MBNA did not result in the discharge of indebtedness but was rather a retroactive reduction of the rate of interest charged by MBNA and thus a reduction of the “purchase price” of the loans under Code Sec. 108(e)(5). The Paynes argued that the lending of money in a generic credit card transaction constitutes the sale of property under Code Sec. 108(e)(5).

The Tax Court said that the Paynes were mistaken. It stressed that MBNA effectively lent them money to be used for health care costs and general living expenses. The only relationship between the parties was that of debtor and creditor, and thus the Tax Court held that Code Sec. 108(e)(5) did not apply.

    Observation: Many individuals may be in a similar situation of needing a credit card workout. While getting the bank to agree to a big reduction in the debt is obviously a plus, as shown in this case, the debt discharge can trigger income. For some, however, the debt discharge income may not have practical tax consequences. For example, if the discharge occurs during a period of unemployment when the individual has little or no income from other sources, the individual effectively may owe little or no tax on it. While there probably is not much latitude to time a settlement, to the extent possible, individuals should try to arrange it during periods when the income from the discharge won’t have severe tax consequences.

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