What is debt forgiveness, COD income?
Debt forgiveness that may result in Cancellation of Debt (COD) income to taxpayers has been a hot topic on the tax circuit for a while, but it seems to be getting more attention today. The reasons are varied and include the fact that more taxpayers are filing for bankruptcy; credit card companies seem to be more willing to settle a debt and take what they can get; and taxpayers are still letting substantial amounts of houses go through the foreclosure process. Each of these examples creates debt forgiveness and possibly COD income.
For example, a taxpayer files for bankruptcy with $200,000 of debt from all sources including house mortgage, credit cards, automobile loans, and personal loans. Total assets equal $130,000. He is insolvent by $70,000. The taxpayer has debt forgiveness equal to that difference.
Another example is the taxpayer has an outstanding balance on a credit card debt of $15,000. He negotiates the pay-off down to $10,000. The $5,000 difference between the original debt and the negotiated pay-off amount is debt forgiveness.
A third example is the pay-off on an auto is $20,000. The car is repossessed and then auctioned off for $12,000. The $8,000 difference would be considered debt forgiveness.
The tricky part comes in applying the correct rules to determine whether the debt forgiveness creates COD income to the taxpayer. Let’s go through the three examples above.
In the first example, the taxpayer files for bankruptcy. His debts are remanded to the bankruptcy trustee and an agreed-upon payment plan is set up. The taxpayer pays into the plan over a number of years. At the end of the period, any remaining outstanding debts are forgiven. There are a tremendous number of exceptions and intricate rules that must be followed, but the bottom line is at the end of the payment period, outstanding debt is forgiven. Because this occurred within the framework of a bankruptcy, the debt forgiveness will not create COD income to the taxpayer. Bankruptcy is the trump card in these instances that doesn’t allow the debt forgiveness to become COD income.
In the second example, credit card debt of $15,000 is settled with a $10,000 payment. The $5,000 of debt forgiveness, in almost every instance like this, will create COD income to the taxpayer. The taxpayer will receive a 1099-C with the details and will report the income on Line 21 of his Form 1040. This is an ordinary income line so the amount is taxable at regular tax rates to both the federal government and the State of Michigan.
A possible exception here involves the solvency of the taxpayer. If the taxpayer can prove that he was insolvent on the day the 1099-C was issued, the COD does not create COD income. The Internal Revenue Service has an Insolvency Worksheet on its website that can be used to list all of the taxpayer’s assets and liabilities. If the liabilities exceed the assets on the date of the 1099-C, COD income is not created. If the taxpayer receives four 1099-Cs dated on different days during the year, he will have to create four different Insolvency Worksheets to determine if COD income is created. Insolvency is the second trump card available to allow taxpayers to not have to declare a COD as income.
In the third example, a car is repossessed and auctioned off with a resulting $8,000 difference. The bank or finance company usually has the right to go after the taxpayer. If it determines the debt is uncollectible, it can forgive the debt and issue a 1099-C for that amount. If the taxpayer hasn’t filed bankruptcy or isn’t insolvent, he is out of trump cards. He will probably have COD income and have to pay tax on that amount.
These are three relatively common examples of debt forgiveness and COD income. Next week, I will look at a couple of instances that involve a taxpayer’s personal residence and rental property. Until then, this is Jerry Coon signing off.
Jerry Coon is an Enrolled Agent. He owns Action Tax Service on Northland Drive in Rockford. Contact Jerry at email@example.com