Tax implications on settlement


N

nat

Debtor defaults on a $2000.00 credit card. Because of fees and
interest, the debt nearly doubles. The credit card company sells this
debt to a third party. Third party sues debtor for over $5000.00
including attorney's fees. If a settlement is reached for $2000.00,
would this be considered income due to a cancellation of debt?
 
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S

Stuart A. Bronstein

nat said:
Debtor defaults on a $2000.00 credit card. Because of fees and
interest, the debt nearly doubles. The credit card company
sells this debt to a third party. Third party sues debtor for
over $5000.00 including attorney's fees. If a settlement is
reached for $2000.00, would this be considered income due to a
cancellation of debt?
Interesting question.

My thought is no, there's no cancellation of debt income. There's
cancellation of claimed debt, but not of established debt. If there
were taxable income in this case, you could cause anyone to have
taxable income by telling him he owes you money, and then telling him
"never mind."
 
A

Alan

Stuart said:
Interesting question.

My thought is no, there's no cancellation of debt income. There's
cancellation of claimed debt, but not of established debt. If there
were taxable income in this case, you could cause anyone to have
taxable income by telling him he owes you money, and then telling him
"never mind."
You lost me with your comment "but not established debt." The
taxpayer defaults on $2000 of credit card charges. Each month
finance charges add to the outstanding balance. Let's say the
balance reaches $4000 when the issuing bank decides to discount
the debt and sell it to a collector. The debt is $4000 when it is
sold at some discounted amount. The collector is betting that
they can make a profit by collecting the $4000 or some lesser
amount that is still above what they paid. If the taxpayer
enters into a settlement for $2000, I believe there would be debt
cancellation income of $2000 (the difference between what the
taxpayer owed to the bank and what the taxpayer paid).
 
M

Mark Bole

Alan said:
You lost me with your comment "but not established debt." The taxpayer
defaults on $2000 of credit card charges. Each month finance charges add
to the outstanding balance. Let's say the balance reaches $4000 when the
issuing bank decides to discount the debt and sell it to a collector.

Did the bank thereby cancel the cardholder's debt with this action?

The debt is $4000 when it is sold at some discounted amount. The
collector is betting that they can make a profit by collecting the $4000
or some lesser amount that is still above what they paid.

They actually tried to collect $5,000, including attorney's fees.

If the
taxpayer enters into a settlement for $2000, I believe there would be
debt cancellation income of $2000 (the difference between what the
taxpayer owed to the bank and what the taxpayer paid).
Somewhere, maybe on this board, I collected an article on this very
topic, from "Tax Analysts - Tax Notes December 15, 2008" by author
Richard C. E. Beck (professor at New York Law School).

Here's an excerpt:

"The Tax Court has recently held in Payne v. Commissioner
that the forgiveness of defaulted interest is taxable
to the borrower, and in Hahn v. Commissioner that
forgiven penalties are taxable as well. This article argues
that those decisions are erroneous. Because those judicial
errors will potentially injure millions of taxpayers, it is
important that the errors be corrected. Payne is currently
on appeal before the Eighth Circuit and should be
reversed."


-Mark Bole
 
A

Alan

Mark said:
Did the bank thereby cancel the cardholder's debt with this action?
No. It sold it. The outstanding balance remains the same.
They actually tried to collect $5,000, including attorney's fees.
I don't believe the attorney fees are relevant for purposes of
debt cancellation. The debt cancelled was the amount owed (in my
example $4000) less what was paid.

I've changed my mind on the interest and finance charges as
taxable income. I started to think about a recourse mortgage debt
and realized the cancelled debt including interest is taxable
because the interest is tax deductible. Therefore, I must
conclude that as long as we are discussing personal debt (not
business debt), only the amount charged would be taxable less any
repayment.
 
M

Mark Bole

Alan said:
I don't believe the attorney fees are relevant for purposes of debt cancellation.
But in getting from $5K lawsuit amount to $2K settlement, how much of
the $3K difference represents canceled principal, canceled interest, and
canceled attorney's fees? If the third party collection agency is going
to issue the 1099-C, I wonder what determines the amounts they put in
Box 2 and Box 3? Maybe it gets spelled out in the court decree?
I've changed my mind on the interest and finance charges as taxable
income. I started to think about a recourse mortgage debt and realized
the cancelled debt including interest is taxable because the interest is
tax deductible.
I don't believe that's correct; Pub 4681 in the section headed "Interest
included in canceled debt" says:

"If the interest would be deductible (such as on a business loan [or
qualified mortgage]) and you do not meet any other exception or
exclusion discussed later, include in your income the net amount of the
canceled debt (the amount shown in box 2 minus the interest amount shown
in box 3) [of Form 1099-C]."

In other words, mortgage interest that would otherwise be deductible if
paid is *excluded* from COD income.

Conversely,

"If the interest would not be deductible (such as interest on a personal
loan) and you do not meet any other exception or exclusion discussed
later, include in your income the amount from Form 1099-C, box 2."

Therefore, I must conclude that as long as we are
discussing personal debt (not business debt), only the amount charged
would be taxable less any repayment.
That's the way I personally think it should be, I hope the legal appeal
mentioned in the article I referenced succeeds.

-Mark Bole
 
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S

Stuart A. Bronstein

Alan said:
You lost me with your comment "but not established debt."
Seems to me that the additional is claimed to be owed by the
creditor, but who is to say it's actually owed? OP may be able to
claim defenses that would wipe out the additional $3000.

Say for example someone walks across your lawn without your
consent, or does some other minor act that you could conceivably
complain about. You tell him that he violated your rights and he
owes you $10,000. He tells you he's not going to pay a thing, and
then you decide to drop the claim.

Can you send him a 1099 for $10,000? Does he have cancellation of
debt income of $10,000? I doubt it.
 

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