Question: If a credit card account has been discharged that enables a tax write-off for the unpaid credit account, why is the debtor required to make payments, as the account could be placed in collections? I view that to be a deceptive practice. Why do I have to pay taxes on cancelled debt? Isn’t the whole point that the debt was cancelled?
— Laurie in California
Jacob Dayan answers…
That is a great question. The answer to your question is relatively straightforward — but as always, I have to caution you that everyone’s tax circumstance is different.
As such, it is often advisable to speak to a tax professional prior to making any decisions related to the information provided on a website — including this one. That’s why Debt.com has experts you can call anytime.
Before I break down the answer, let’s review some basics about collections and taxes…
Why do I have to pay taxes on a debt that’s been written off? And this is Taxing Questions.
Hi, I’m Jacob Dayan, CEO & Co-Founder of Community Tax
Your credit card might be plastic, but the company that issued it to you deals in paper. So, you can’t write off any cancellation of debt until the credit card company issues you a form called a Cancellation of Debt. This isn’t an uncommon situation, but it is a confusing one to many people.
In fact, if I’m asked to rate the difficulty of this topic on a scale from 1 to10, Cancellation of Debt is around a 7.
You might ask, why so high? Because the IRS and your credit card companies don’t advertise the solutions to your problem. And while they aren’t hiding them, either. Trying to figure out a Cancellation of Debt on your own is both time-consuming and confusing.
Having someone on your side, looking out for your best interests, can save you thousands of dollars. If you call Debt.com, you can consult with myself or a member of my team right away.
The short answer is that a credit card company will “write-off” a debtor’s balance after months, if not years, of collection efforts. The credit card company will issue the debtor and the IRS a 1099-Cancellation of Debt.
What this means is that the debtor — you — is then required to pay income tax on the amount of debt that was canceled or forgiven. The IRS essentially treats any unpaid forgiven debt as income. And you definitely don’t want to ignore the IRS. If you want to know what happens if you do, read the Debt.com report, Understanding the IRS Collections Process.
There is, however, an exception to the requirement of paying taxes on any canceled credit card debt. A taxpayer will not be responsible for paying taxes if they can prove they are insolvent at or before the cancellation of debt.
Insolvent means that you have no assets, and your financial situation is upside down. Credit card companies will generally wait three years before issuing a 1099-Cancellation of Debt. Why? Because they must show a consistent attempt to collect the unpaid balance. (This is just part of the rules that govern collections. Read more at How Debt Collection Works.)
Credit card companies are not in the litigation business, so they tend to sell past due accounts to law firms that will collect on the outstanding debt. If a credit card company fails to collect after roughly six months they may engage a collections law firm to take over collections. The law firm will try to work out payment of the debt prior to filing suit in civil court. After three years of attempting to collect, the credit card company will finally “write-off” the debt and issue a 1099-Cancellation of Debt.
I hope this helps clear things up. If you have any other questions, my tax team can give you a free consultation. Just call Debt.com.
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Jacob Dayan was born and raised in Chicago and worked in New York City as a financial analyst at Bear Stearns. In 2009, he returned to Chicago to be with his family and pursue a career assisting consumers and small businesses with various financial needs. In 2010, he co-founded Community Tax LLC, a full-service tax company helping customers nationwide with all of their tax resolution, tax preparation, bookkeeping, and accounting needs. He’s a licensed attorney in Illinois who graduated Magna Cum Laude from Mitchell Hamline School of Law and has worked with more than 60,000 clients – resolving more than $400 million in tax liabilities.
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