MA Bankruptcy – Settle with Credit Card Company? Then you pay taxes . . .

April 12, 2010

By Kara O’Donnell, Bankruptcy Attorney

Occasionally people with credit card debts (who are usually past due) will get notices in the mail from a collector which offers to settle a credit card debt. Sometimes these offers are for 50% of face value of the debt. But there are 2 problems:

1) You will only get this notice if you are already past due on your credit cards minimum payments. And if you cannot afford the minimums how will you settle for 50% of the bill, especially when they want the payments in a lump sum?

2) Your balance is $20,000 but the collector is offering to settle for $10,000. Sounds great? Maybe you sell a car to get the money or borrow from a relative, but then comes the surprise sometime around tax season . . . a 1099-C form for $10,000. The 1099-C form is for cancelled debt and you must file it with your return. The IRS will treat that $10,000 as taxable income – same as if you got a bonus from a job or gambling winnings. Depending on your income tax bracket that $10k “gain” that you got (from the written off/cancelled debt) will be subject to 25-40% in taxes.

HOWEVER, while cancelled debt may create an income tax liability, discharged debt does not. Under the U.S. Bankruptcy Code, if a debt is discharged in a bankruptcy case, it does NOT count as taxable income. Bottom line? In a Chapter 7 bankruptcy, you will get your unsecured debts, such as credit cards, discharged and NO 1099-C will show up at tax time.

This is just another reason why the decision to use a debt management company needs to be very carefully considered prior to giving them any money whatsoever. They cannot prevent the IRS from knocking on your door wanting to tax you on the cancelled debt.

Is it possible for a bankruptcy filer to get a 1099-C for discharged debt?
This has occasionally been known to happen. (Those creditors are sneaky!) However, the filer needs only to know the law is on his side and to file IRS Form 982. This will exclude the amount of discharged indebtedness from your gross income. (Remember – there is a very big difference between cancelled income and discharged income.)

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