If a bank forgives a debt, the bank gets a tax write-off. But oftentimes it counts as income for the consumer. That means those who could not pay a bill suddenly have to pay a tax.
Fred Trapkin had open heart surgery, then lost his job, and fell way behind on paying his bills.
"My credit card balance just kept getting bigger and bigger and bigger, and finally got to the point where I just couldn't pay it anymore," said Trapkin.
Trapkin wound up owing $48,000 on his Chase credit card. The bank sent his account to collections, and when Trapkin still could not pay, the collection agency offered an irresistible deal.
"You just pay us the $10,000, boom your account is paid," he said.
The deal was Trapkin would pay $10,400 of his credit card balance, and in exchange, Chase Bank would cancel the remaining $37,700 of the debt. He gladly accepted.
"Yeah, I'd be crazy not to take it," he said. "The debt is paid. I'm home free."
Except, not exactly. Trapkin was shocked to receive in February a 1099-C "Cancelation of Debt" form filed with the Internal Revenue Service. It means Trapkin must now pay income taxes on the $37,000 of forgiven debt. So, he no longer owes the bank, but he does owe the federal government.
"I took one look at it and I go, this is not right," he said.
"It's kind of a double-edged sword here [because] you're trying to get rid of the debt and then you end up owing more taxes," said Dan Parrish with Consumer Credit Counseling.
Parrish says many banks these days are offering to settle credit card debt with struggling consumers; banks wrote off a record $83 billion worth of credit card debt last year alone. And consumers, he says, are often shocked to then be hit with a tax.
"That's unfortunate when the creditor doesn't 'tell you, 'Oh, by the way, John Doe or whoever, we'll settle for less than the full balance, but we're going to have to report this as income,'" said Parrish.
"I would have thought twice," said Trapkin. "I wouldn't have accepted the deal."
Trapkin says the collection agency should have told him he could be hit with a tax if he agreed to the deal.
"The fact that they knew about it and didn't disclose it, that to me is wrong," he said.
So Trapkin called 7 On Your Side and we contacted the collection agency, Creditors Interchange. CEO Gary Holter said, "Company policy is to discuss tax liability with debtors during settlement talks." However, it is "not a specific written policy." He also said "...it is not clear if anyone actually discussed the tax with Trapkin" and that "the information also should have been included in his debt settlement letter, and it was not."
Chase Bank, which accepted the deal, would not discuss Trapkin's case, but said, "We always do our best to ensure customers receive clear and straightforward information about their accounts."
Trapkin is now left to deal with the IRS. He could owe thousands of dollars in these unexpected taxes, due in just a couple of weeks.
"Uncle Sam is much less forgiving," he said. "April 15th, they want their money."
If you are in bankruptcy or are insolvent when the debt is forgiven, the federal government will not make you pay taxes. Also, forgiven debt on a short sale of your primary house is not taxable by the federal government, at least not right now.
For basic rules, see Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments
If the cancelled debt can be excluded as income, see Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness