Your debt is forgiven, but your taxes are not

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Here’s a bit of unhappy news for tax season. The folks over at point out that even if your credit card company has forgiven the debt you owe them, there’s still a good chance you have to pay tax on the amount. That caveat is going to catch a lot of people this year since, as Steve mentioned a few weeks ago, card companies have been on a charge-off binge. According to

There was a surge in credit card debt forgiveness in 2009. According to the IRS, more than 2.5 million people will be receiving 1099 forms, because they owe income taxes on forgiven debt from car loans or credit cards.

Now, if you’re in bankruptcy proceedings or insolvent (that is, you owe more than the value of all your assets, including your house, car, furniture and investments), then you don’t have to pay tax. Lucky you! Otherwise, you’ll be receiving a 1099 and will be obligated to pony up.

That sounds a little stupid, right? If a profit-seeking company has decided you’re a lost cause, why does the government think it can get money out of you?

Here’s the logic, from the IRS web site:

When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender.

That actually does make sense to me, but, again, whether people will have the means to pay those taxes is a different issue.

A few years ago, Congress temporarily changed the law on this sort of thing for mortgage debt forgiveness. If your bank writes down the value of your primary residence, in most cases you don’t owe tax on the amount forgiven. That’s an upshot for any loan modification folks who have seen their principal reduced. There aren’t too many people in that boat yet, but that may be changing.