Consumers beware – you may have skated past the creditor, but you may not be as lucky with the I.R.S.
Many people who get sued for debt usually compromise those claims in some fashion. In fact, many collection lawsuits that are filed are settled before trial. These settlements may include a reduction in principal. If someone gets sued by a debt buyer and is smart enough to stand up to that debt buyer by demand discovery of signed documents, then the consumer may be get off, scott free, from the debt. “So whats the problem, Gary” you may ask.
Under the Internal Revenue Code of 1986, (and don’t go to sleep on me now), any debt that is forgiven is now taxable income to the debtor. In fact, it is called “Cancellation of Debt” income, or COD. COD arises when a consumer becomes obligated to pay back less than the principal amount of the loan. For example, if we defend our client in a $10,000 lawsuit and settle the case for $3,000, our client will have to report that $7,000 difference as taxable income. This means that our defense clients will sing our praises right up until April 15. COD is taxed as ordinary income. There are some exclusions to COD income.
One exclusion to COD income involves the forgiveness of debt in restructuring the mortgage on your home. Under the Mortgage Forgiveness Debt Relief Act of 2007, you may exclude up to $2,000,000 of debt that is forgiven in connection with the restructuring of your mortgage debt. As with most tax issues, there are certain conditions, exclusions, and must be present to win clauses which is why I am including a link to that act. Please note that this act applies to debt restructuring that takes places between January 1, 2006 and before January 1, 2013. This window does appear to be closing.
A second major exclusion from COD income involves bankruptcy. To the extent that you get a discharge in bankruptcy, COD income may be excluded. This is somewhat of an oversimplification of the rule. If you need specific advise on how this exclusion works, you should talk with your accountant tor attorney. Just know that this rule is out there.
There are some other exclusions to COD income, but they are beyond the scope of this blog post as they generally do not apply to consumers.
Moral of the Story – Consumers – when your debt is forgiven, there is a taxable event. When your attorney negotiates a settlement on your behalf, be sure to account for the taxes that you will be responsible for on the forgiveness of this debt. Also, note that if you are considering a restructuring of your mortgage debt, that the Mortgage Forgiveness Debt Relief Act of 2007, you may exclude up to $2,000,000 of COD income. However, there is a time limit currently in place on this act. Hence, if you are contemplating a restructuring of your home mortgage, do not delay!