If a credit card company charges off your debt, it gives up on receiving repayment and chalks up the amount as a loss. However, this doesn’t mean you’re no longer responsible for the debt in question. Not only can collection agencies sue you for repayment, but you will also see a decreased credit score and may even face tax consequences. Here’s what you need to know about how credit bureaus and the IRS treat a credit card write-off.
Typically, a so-called charge-off occurs after you’ve failed to make a credit card payment for at least 180 days.
Sometimes, the credit card company will cancel the charged-off debt. Although this means you are no longer responsible for the past-due amount, it also means you will have to report the canceled balance as income if it exceeds $600. At tax time, you’ll receive a copy of Form 1099-C Cancellation of Debt, which is also sent to the IRS. Failing to report this amount when you file your taxes may result in an unaccepted tax return or a reassessment of your tax liability after you file.
If you enter a debt settlement agreement with your credit card company, it agrees to write off and forgive a portion of your debt. This will also result in a Form 1099-C that must be reported at tax time. Consult with a CPA about your potential tax consequences before accepting a proposed debt settlement arrangement. Make sure you find a professional who has experience with this type of filing.
Although the IRS once urged creditors to issue a 1099-C for any debt that has gone unpaid for 36 months, regardless of whether it was forgiven, this practice was canceled in 2016. If you receive a 1099-C for a debt that is not listed as canceled on your credit report, contact the credit card company. It must either rescind the 1099 form or cancel the debt, which means it must forego collection actions.
If the credit card debt in question was for a business expense, the forgiven amount will be taxed except for the interest. That’s because the interest on business costs is tax-deductible.
If you’re struggling to pay your credit card bills, you likely can’t afford to pay the additional taxes associated with forgiven debt. The IRS will waive taxes on the 1099-C amount if you can prove you were insolvent, which means your debts exceed the value of your assets. To qualify, you will need to provide comprehensive financial information using IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.
If you file for bankruptcy, you will not be taxed on discharged debt. However, the credit implications of a Chapter 7 or Chapter 13 bankruptcy filing are severe. Talk to a bankruptcy attorney about whether filing would be beneficial if you have significant unsecured debts you are unable to repay. Credit card and medical debts are completely forgiven with Chapter 7 bankruptcy, while Chapter 13 restructures your debts to make them more affordable. Either way, you avoid the tax consequences associated with debt settlement.
Creditors are not legally required to inform customers about the tax consequences of forgiven or canceled balances. If you’re in the process of negotiating debt relief or a settlement, you should consult with a CPA about the tax consequences of any proposed plan. The assessed taxes on the forgiven amount will vary based on your individual financial situation.
If you already paid tax on the forgiven income even though you may have qualified for the insolvency exception, you can go back and amend your returns to take advantage of the exception if the error occurred within the past three tax years. You will have to show that your debts were greater than your assets for the year in question. This paperwork can be complex, since you have to calculate the fair market value of all your property.
If you own a home or other assets, you may be unable to qualify as insolvent even if you are in significant debt. That’s why it is important to work with a qualified CPA. IRS Publication 4681, Cancelled Debts, Foreclosures, Repossessions, and Abandonments, provides a worksheet you can use to calculate insolvency.
Low-income taxpayers are disproportionately affected by taxes on forgiven debt. IRS data from 2009 shows that fewer than 12% of individuals who received a 1099-C for canceled debt filed for the insolvency exception, even though a much higher percentage qualified for the Earned Income Tax Credit for low-income individuals. However, just because you can amend your tax return to claim the exception doesn’t mean it’s advantageous to do so. Sometimes, the lower tax burden means you could lose your EITC and end up owing more than you otherwise would. Again, nothing replaces the advice of a qualified tax professional.
When you receive a 1099-C, always check to make sure the information reported is correct. This is especially true when you receive a cancellation form for old debts. Although creditors aren’t supposed to report debts to the IRS after three years have passed, this is not always enforced. You should also make sure the discharge date of your debt is listed correctly, since that date will come into play if you want to claim insolvency.
It’s up to you to dispute the 1099 information if necessary. If anything is incorrect, your creditor must issue a corrected form. If they don’t do so, you can submit proof of the required change to the IRS. You should also confirm with the creditor that the debt has in fact been canceled. Regularly review your free credit report at annualcreditreport.com.
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