In a case brought under the FDCPA, debt collectors do not have to provide the consumer information on tax liability for debt forgiveness income.

A common debt collection settlement will include an agreement by the creditor to waive a portion of the amount owed, provided the remainder of the account balance is paid off.

Be sure to consider what debt cancellation tax you may incur before signing or paying a debt settlement. You cannot rely on the debt collector informing you about such things. This is the decision reported May 20, 2015 by the presiding judge in a Fair Debt Collection Practices Act (FDCPA) lawsuit on appeal to the U.S. Court of Appeal. [1]

The debt collector J.C. Christensen & Assoc. Inc. was the culprit behind the allegedly deceptive collection practice. The Court of Appeals stated that, provided the debt collection agency informed the consumer of the delinquent account balance at the time of the settlement, the consumer was aware of the amount of debt that had been written-off. The obligation to inform a consumer of his/her tax accounting requirements does not fall on the debt collector.

This is one reason why our law firm provides our clients with written notice of possible tax liability for debt forgiveness. Such tax liability is reported by the creditor to the IRS on a tax form 1099-C. The form 1099 is used to report “miscellaneous income” and the “C” represents “Cancellation of Debt Income.”

As an example of why forgiven debt is taxed, consider the following hypothetical scenario:

You borrow $10,000 from the Bank.

You do not pay income tax on the $10,000 you received, because you are not allowed to keep that $10,000. The loan agreement requires that you repay the $10,000 to the Bank, plus interest.

But you experience financial hardship and you default on repayment of the $10,000 to the Bank.

The Bank sends you debt collection notices, and entices you to settle the debt for $6,000. The Bank agrees to forgive the remaining $4,000 of debt.

At this point, the $4,000 of cancelled debt has become income to you, because you have negotiated an exception to the Bank’s loan agreement allowing you to keep the $4,000 and releasing you from having to repay it to the Bank.

The problem for most people in this situation is they have already spent the $4,000, without saving a portion to pay the income tax they have no incurred.

Nevertheless, having to pay tax on $4,000 of income still beats having to repay the $4,000 all together.

Even better, just because you receive debt forgiveness income, it does not necessarily mean you will owe money to the IRS. The tax can be avoided to the extent of your insolvency, meaning if you have other debts or losses, it can cancel out the tax you incur. [2] [3]

If you would like legal assistance negotiating debt forgiveness, and understanding debt collector disclosures, contact our law firm for a free consultation.

[1] Altman v. J.C. Christensen & Assoc., Inc., 14-2240-cv, NYLJ 1202726711180, at *1 (2d Cir., Decided May 14, 2015)

[2] IMPORTANT DISCLAIMER: This article is for information purposes only and does not constitute legal or tax advice. You should consult an accountant for tax advice, including taxation of Cancellation of Debt Income.

[3] IRS 230 Disclaimer: As required by new rules imposed by the IRS, please be advised that any U.S. tax advice contained in this communication (including attachments) is not intended nor written to be used, and cannot be used, for the purpose of (i) avoiding penalties by the recipient hereof or any other taxpayer under the Internal Revenue Code, or (ii) promoting, marketing or recommending to the recipient hereof or any other taxpayer, a partnership, or other entity, investment plan, arrangement, or transaction on tax related matters addressed herein.