Debt That Is Forgiven By Creditors Is Considered Income

By Alan and Brian, CPA

I had someone make a statement at work that I wanted to look into. Since it was a money related, I asked Brian who is a CPA. I wanted to know: If you have a $10,000 debt to a credit card company, and through negotiation (because you can't pay the full amount), they relieve $5,000 of debt in order for you to only pay $5,000, is it true that the credit card company will issue a 1099 to the IRS in the form of income given to you? Are there times when this would not happen? This seems like this isn't really talked about, if true.

Brian answered: It's called "cancellation of indebtedness" income. It is most certainly real. I've seen it more than once. In general, ANYTHING of value you get is either an exchange for something you give (a purchase/sale), a gift, or taxable income. When you are relieved of debt because the card issuer settles for partial payment, there was no purchase/sale as part of that transaction, and credit card companies don't do gifts. The only remaining way to categorize it - it's income. I could bore you with the Internal Revenue Code reference, but I won't. The fundamental structure of the tax code is, ANYTHING you get of value is income UNLESS it fits a specific non-income category, while deductions are allowed ONLY if they fit a statutory "bucket."

There have always been limited ways out. In general, if you are insolvent - very strictly defined as assets less than debt - to the extent of the insolvency you can avoid recognizing cancellation of indebtedness ("COD") income. But if you're simply too illiquid to pay the debts, but have a big house, you're stuck.

Frankly, the creditor tends to enjoy issuing that 1099, as from THEIR perspective they just got stuck by giving up a large chunk of what was owed. I know, it's hard to feel for the big bad credit card issuer. But it also applies to the small business owner that just got stuck with this, too, and figured getting 40% was better than getting maybe a bit more (or less) and giving 1/3 or more of that to the lawyers to pursue collections.

I've seen it on individuals that got in over their heads with credit cards, and business owners left holding the bag on deals gone south due to the economy.