Canceled debt can become a tax liability

Bills are piling up to the point where you dread opening your mailbox. If only your creditors would forgive your debt. Sometimes, they will -- but even then your money troubles might not disappear. Canceled debt in many cases is considered taxable income. And if a creditor forgives thousands of dollars of debt, you can find yourself whacked by a big tax bill. And that is not the only consequence. Forgiven debt can raise your income to the point where you're ineligible for certain credits and tax deductions, or part of your Social Security benefits is taxed, said Bob Scharin, a senior tax analyst with Thomson Tax & Accounting. Of course, having a creditor absolve you of debt can be a financial lifesaver. Still, a tax bill isn't what many expect when debt is being erased. "People definitely are initially shocked," said Robin McKinney, executive director of the Maryland Cash Campaign, which helps lower-income taxpayers file returns. McKinney said she sees many such cases of shock now with car loans. The cars are repossessed and the loan balances wiped out, yet consumers receive a form saying they owe taxes on thousands of dollars of forgiven debt. "Some people have even said, 'If I had known this was a consequence, maybe I would have tried harder to refinance the loan,' " she said. Credit-card bills are one of the most frequent types of forgiven debt -- and it is taxable.Scharin notes an instance in which a consumer owed $21,270 on his credit card in 2004. The issuer, MBNA America Bank, agreed to accept about $4,600 to settle the debt. But the consumer balked at paying taxes on the $16,670. He argued that the settlement was a retroactive lowering of his interest rate and that he had repaid the principal. A tax court recently ruled against him.Home-mortgage debt is another area where many are trying to negotiate relief. Given the rise of foreclosures, Congress granted a temporary tax break for those whose housing debt is wiped out. Under the new law, you won't have to pay taxes on up to $2 million of forgiven debt on a primary residence. Any debt wiped out on a second home is still subject to tax. If the bank forgives the home-equity loan you used to make substantial improvements to the house, that won't be taxed, either, Scharin said. But if that home-equity loan was taken out for other reasons -- say, to buy a car -- then the forgiven debt will be taxed. Again, this tax break is temporary. It applies to mortgage debt forgiven last year and through 2009. Students, too, can catch a break. Many student-loan forgiveness programs are available if borrowers work in particular fields, such as nursing or teaching, after graduation. This debt relief is not taxed, Scharin said. Steve Hannan, executive director of the Maryland Consumers Rights Coalition, said negotiating for debt relief "is a good move," but you must realize the tax consequences. He advises consumers to obtain any settlement in writing and find out if the creditor will notify credit-reporting agencies that the debt is forgiven. "It doesn't do any good if the debt has been forgiven but nobody knows about it," he said. Keep all documentation to prove the debt was forgiven, in case a debt collector in the future tries to collect it again, he said. While credit-card debt generally is taxed, it won't be taxed along with any other debt that is canceled in cases of bankruptcy or insolvency. As for documents, if you have $600 or more of canceled debt, you will receive a Cancellation of Debt form, or 1099-C, for tax purposes. (Even if the amount is less than $600, you are expected to report it as "other income" on your tax Form 1040.) The IRS wants you to pay taxes on a pay-as-you-go-basis, McKinney said. If it looks as if you will owe a chunk of taxes on forgiven debt, you should pay estimated taxes on the amount or risk being hit with a penalty later, she said. If you don't have the money to pay the tax bill, you'll have to set up a payment plan with the IRS, she said.

Private Collection, Public Loss

Christopher Brauchli

Boulder

May
11
2008

Private Collection, Public Loss

My civil neighbor, the tax-gatherer, is the very man I have to deal with, for it is, after all, with men and not with parchment that I quarrel,-and he has voluntarily chosen to be an agent of the government.
— Henry David Thoreau, Civil Disobedience

It was impossible to know how it would turn out. Of course, there were a few hints. But they were so subtle that only someone with a bit of brain would have picked up on the clues.

Turning delinquent taxpayers over to private collection firms that make contributions to politicians instead of letting the Internal Revenue Service attend to that mundane task seemed like a great idea. So great, in fact, that no one in the Bush Administration foresaw the disastrous outcome.

The idea got its start as a result of the American Jobs Creation Act of 2004. The purpose of the act was not simply to create jobs. It was to transfer to the private sector a number of jobs that had been performed by the public sector - an almost certain guarantee of success since conventional Republican wisdom is that whatever the public sector can do, the private sector can do even better. (That approach reached its zenith in Iraq where President Bush turned over lots of the work formerly done by U.S. troops to private contractors who, it was believed, could do it more efficiently and cheaply than U.S. government personnel.)

In 2005 the IRS began farming out delinquent tax collections to private collection agencies. Three debt collection agencies were initially used and two of them had special qualifications for the work. They had made significant financial contributions to politicians. Pioneer Credit Recovery came from the district of Rep. Thomas M. Reynolds of New York and one of the things that qualified it to be a debt collector for the federal government was that it had given congressional candidates and political action committees $117,450 since 1995. Mr. Reynolds received $16,250.

Linebarger Goggan Blair & Sampson of Austin, Texas and its employees and spouses gave political candidates and PACs of both parties more than $400,000 between 1995 and the time the program was started. After 2007 the firm was fired although the government isn’t saying why that is. It might have to do with the fact that the firm made a $2000 donation to the mayor of Mansfield, Texas a month after he was elected or it may have had to do with the vacation it paid for a contract officer in Chicago that got the firm fired from doing work for that city.

Mark Everson who was the commissioner of the IRS at the time outsourcing tax collection was put in place admitted that outsourcing tax collection is more expensive than keeping it in-house. He nonetheless supported the privatization of collection efforts claiming he could not get sufficient funding to permit him to hire more public sector tax collectors. Following that ill-fated decision Mr. Everson left the IRS to head up the Red Cross where he served only long enough to begin an affair with the member of his staff that resulted in his loss of the job.

According to a report in the Washington Post the private collections program has been a disappointment. The goal of the program was to collect $1 billion from deadbeats owing $25,000 or less. Instead, most of those folks have gotten a tax holiday. Instead of collecting $1 billion, the private debt collectors only collected $49 million. The cost of the program was $98 million suggesting, to the mathematically swift, that it produced a net loss of $49 million.

Commenting on the program in a statement on the floor of the Senate(pdf), Sen. Ben Cardin of Maryland observed that the IRS was losing at least $81 million a year by using private debt collection companies. That's according to Nina Olson, the National Taxpayer Advocate who told Congress that if the $7.65 million spent by the IRS to operate the program were spent instead on its automated collection system it would generate $153 million in revenue. Not everyone would agree with her.

Rep. Jim Ramstad is the ranking Republican on the Ways and Means Oversight Committee. He is unimpressed by the statistics furnished by Ms. Olson. He said the “real choice is whether we use private collection agencies or let these tax debts go uncollected. I hope we don’t take an enormous step backward in our efforts to close the tax gap by eliminating a program that’s working.” He didn’t say what part of the program is working. He’ll probably want to explain to Ms. Olson and Senator Cardin (and Sen. Byron Dorgan of North Dakota, another critic) the part that is working since they are apparently unaware of its successes. He may also want to explain it to his constituents.

Posted by Christopher Brauchli at 6:20 PM |