“Forgive us thy debts”…but it still may be taxable

An important part of debt resolution is the income tax consequences to the debtor. A fundamental principle is that gross income generally includes “all income from whatever source derived.” This generally includes cancellation of debt income (CODI). But, there are instances where CODI is not taxable. An exception applies if the debtor is insolvent and not in bankruptcy. Also, CODI is not taxable if the debtor is in bankruptcy – so long as the debtor has enough tax attributes to soak up the CODI. Also, solvent taxpayers that are not in bankruptcy that negotiate a reduction in the selling price of assets do not have to be reported as CODI. In late, 2007, the Congress tacked on another exception. This one is available for tax years 2007-2009, and provides that acquisition indebtedness that is forgiven on a mortgage attributable to the taxpayer’s principal residence (up to $2 million) is excludible from gross income. But is there any relief for forgiven credit card debt?

In late 1992, the petitioner opened up a credit card account with MBNA America Bank. He used the credit card to pay hospital bills and receive cash advances during times that he was unemployed. By early 2004, he had racked up over $21,000 on the credit card. In late 2004, MBNA agreed to accept a little less than $5,000 as a full settlement of the account balance to be paid in installments over four months. The petitioner made the payments and MBNA issued him a Form 1099-C to report the $16,678 of CODI. However, the petitioner did not report the CODI on his 2004 return. He wasn’t insolvent or in bankruptcy, so he argued that the forgiven amount wasn’t CODI but was a retroactive reduction of the interest rate that MBNA charged. In effect, a negotiated reduction in the “purchase price” of the loans under I.R.C. §108(e)(5).

The court didn’t agree with the petitioner’s theory. Lending of money is not a sale of property for which the purchase price can be renegotiated, and the parties were not buyer and seller, but debtor and creditor. So, I.R.C. §108(e)(5) didn’t apply.

So what’s the lesson of the case? For tax years 2007-2009, a taxpayer in the petitioner’s situation should consolidate credit card debt with the home loan (i.e., “monetize” the home through borrowing). Any subsequent default on the loan does not result in taxable CODI. If it’s just credit card debt, however, the forgiveness results in taxable CODI. Payne v. Com’r, T.C. Memo. 2008-66