Not every unpaid debt results in cancellation of debt income to the borrower under the IRC Section 61(a)(12).
Often medical debts and credit card debts are genuinely disputed. Hospital bills contain many errors and patients should question charges not understood. Similarly, credit card bills may contain disputed or unauthorized charges. These amounts not routinely resolved may ultimately result in payment of a lump sum settlement amount that is less than the original charge. In McCormick v. Commissioner, T.C. Memo, 2009-239 (2009), the McCormicks settled disputed credit card debt for a lump sum; but, the bank issued a Form 1099-C. The Tax Court held there was no cancellation of debt income when the disputed amount was settled. In effect, the settlement amount becomes the amount of the debt for tax purposes. It is also important to monitor your credit bureau file that incorrect or disputed items do not negatively impact your credit score. Prompt and tenacious action should seek to correct errors. A lawyer’s assistance may be required.
When mortgage debt is not being paid the property may be abandoned, the bank may re-aquire the property via a short sale or foreclosure and/or the bank may sue for a deficiency judgment. The borrower may receive Form 1099-C, Cancellation of Debt, or Form 1099-A, Acquisition or Abandonment of Secured Property. The borrower may realize a gain on the foreclosure or short sale depending on how long ago the property was purchased(i.e., whether present FMV is lower than tax basis) and may also have cancellation of debt income. In that case the bank will issue Form 1099-C. If the bank has not released the debtor, however, the bank should issue Form 1099-A. In that case the cancellation of debt determination is postponed until the statute of limitations runs on the debt. If debt up to $ 2 million (married couples) is secured by a qualifying principal residence, the delay won’t matter for most. If the property is a second home, vacation home, rental or business property, the borrower is frequently insolvent now but may become solvent down the road when the debt becomes un-collectible. Thus, the borrower may want the debt cancelled now to take advantage of the insolvency exception to recognizing cancellation of debt income, even if it means taking a bigger credit score hit.
The borrower should not assume that the Form 1099-C or Form 1099-A is correct. Verify all information on the Form including the name of borrower, address of property, date of acquisition by bank, if applicable, principle balance, interest included (1099-C), FMV (if appropriate inquire of the basis for arriving at the FMV) , and personal liability status.
A borrower may be able to recover damages against a bank, medical services provider or collection agency negligently reporting erroneous information to a credit bureau or violation the Fair Debt Collection or Fair Credit Reporting Acts; and, as did Carolyn Eifert (Eifert v. Commissioner, T.C. Memo 1997-214), a taxpayer may be able to recover attorney fees should IRS unreasonably rely on suspect Forms 1099 in making its deficiency determination.