Why Do I Have to Pay Taxes on My Cancelled Debt?

September 7, 2012 by · Leave a Comment
Filed under: Taxable Income 
Steve

Photo by Steve Snodgrass at Flickr.com

This is one of those questions I hear all the time: Why do I have to pay tax on my cancelled debt?  It’s not income so why am I being hit with income tax?

 

Here’s the situation—you’ve rung up some credit card bills and then you couldn’t afford to pay them off.  You make a deal with the credit card company (or more likely a debt collector) and you agree to pay half of it and they cancel the rest of the debt.  Sounds like a pretty sweet deal doesn’t it?

 

At least it sounds like a sweet deal until tax time.  What happens then is that you get a statement called a 1099C form which shows that your debt was cancelled and it becomes taxable income to you.   Not so sweet.

 

But why does it count as income?  This one’s easier to explain with an example.  Let’s say you charged $20,000 worth of stuff.  Let’s say you bought shoes, clothes, a big screen TV and some furniture all on credit.  Or maybe you charged medical bills and food.  It doesn’t matter what you did to acquire the debt.  The results are the same.  Then let’s say you lost your job and couldn’t pay for it.  The credit card company charges interest on the amounts not paid and the bill goes up to $23,000.  You’re in over your head so you get some help from a credit card counselor.  With a loan from your parents you settle the bill for $13,000.  Now you’re free and clear of the debt.

 

But tax time comes and you get a 1099C stating that you have income of $10,000 which is the amount of your credit card debt that the credit card company forgave.

 

It’s counted as income, because unlike your parents, the credit card company didn’t make it a gift.  For the credit card company, if they write off your debt, it’s a business expense, and that makes it a deductible business expense to them.  If they were to just give you a gift, that’s not a deductible business expense.

 

You might be thinking that it’s not fair—but in reality, it’s not only fair, but it’s absolutely necessary.  You see, the credit card company has to report what you charged as income.  Let’s take that TV as an example.  You charge $1,000 for the TV and the credit card company is required to pay $1,000 to the store.  They record the $1,000 as income to the credit card company and then they expense the $1,000 they paid to the store—they haven’t gotten the $1000 from you yet, but since you’re going to pay it, they report the income.  It’s called accrual basis accounting.

 

But now you’re not going to pay them.  They’re already out the $1,000 they paid to the store for your TV and now they’re not going to get the money that they’ve already had to pay their income tax on.  So when they get to the point that they’re going to cancel your debt—well they have to issue you the 1099C to prove they cancelled the debt and claim their tax deduction.

 

But why do they add the interest into it?  Once again, they already counted the interest that you should have been paying on that debt as income.

 

Remember, it takes money to pay for things you want and need.  We pay for those things with our income.  Usually we think of income as wages, but if we buy stuff and then don’t pay for it, that’s also a kind of income to us as well.

 

For more information on cancellation of debt, see my blog post titled How to Report Debt Forgiveness (1099C) on Your Tax Return.

How to Report Debt Forgiveness (1099C) on Your Tax Return

September 4, 2012 by · 3 Comments
Filed under: Taxable Income 

In my last post I wrote about why debt forgiveness counts as income, but I didn’t explain how to report it on your tax return.  And it’s important that you do report it, or you’ll be getting a nice little letter from the IRS asking you why you didn’t.

 

First and foremost, if you received a 1099C for cancellation of debt on mortgage interest, you should be reading a different post.  See:  http://robergtaxsolutions.com/2011/11/what-you-need-to-know-if-your-mortgage-debt-is-forgiven/ What I’m talking about here is cancellation of credit card debt.  It doesn’t get treated in exactly the same way as mortgage interest.

Generally, if you receive a 1099C statement, I think you should see a tax professional—and make sure it’s someone who’s worked on debt cancellation issues before.  Not everybody does that.  I once had a client who had called around and I was the 5th person he called before he found someone with debt cancellation experience.  He had started at one of those big box tax places and was told that he owed the IRS $14,000.  That’s when he started thinking he wanted a second opinion.  When I did the return, he actually had a refund.

 

To be fair, his case was unusual and he managed to catch all the breaks in the tax code—but if he didn’t  have someone who knew the tax code and where the breaks were—well then he would have been paying $14,000 in income taxes that he didn’t really owe.

 

So how do you report income from cancellation of debt?  Basically, it goes on line 21 of your tax return, in the other income category.  It gets taxed just like anything else that goes on that line—at your regular income tax rate.   That’s what happened with the $14,000 fellow—his preparer put his 1099C income on line 21.  While that’s the correct way to report 1099C income, she had neglected to look for exceptions to see if some (or all) of it might not be taxable.

 

The two most common exceptions to having your 1099C income being taxed are bankruptcy and insolvency.  In bankruptcy, you’ve actually filed for bankruptcy and your case is either under the jurisdiction of the court and the court has granted a discharge of indebtedness—or is under a plan approved by the court.  Bottom line—you’ve got the legal paperwork to back up your claim that you should be exempt from tax on your cancelled debt.

 

With insolvency—it means that your liabilities exceeded the fair market value of your assets immediately before the discharge.    Okay, in English.  Let’s say you owed $10,000 on a credit card—that’s a liability.  Your assets included a car, some clothes, a TV, a little cash in the bank that the value of all that totaled $7,000.  Since your liabilities (the $10,000) are more than your assets (the $7,000) you are insolvent by $3,000.  So if the credit card company discharged $5,000 of your debt, you would be able to exclude $3,000 from tax but you’d still pay tax on the $2,000 that you weren’t insolvent on.

 

To report an exclusion of cancelled debt from taxes, you’ll need to use Form 982.  Here’s a link to that:  http://www.irs.gov/pub/irs-pdf/f982.pdf

 

If you think you might qualify for the insolvency exclusion, you’ll want to fill out the worksheet located in publication 4681, it’s on page 6.  http://www.irs.gov/pub/irs-pdf/p4681.pdf

 

Now to be perfectly honest, I’ve really oversimplified this for the sake of brevity.  Many people will have cancelled debt and won’t qualify for any tax forgiveness.   Also, it’s important that you don’t file for tax exclusions if you don’t qualify for them (it’s a type of fraud—you don’t want to go there.)  And it’s quite possible that you can do everything right with the 982 form and you’ll still get a letter from the IRS asking you to confirm something.  (That actually happens quite often so don’t be surprised—it’s pretty normal.)

 

There are two really important issues you need to learn from this blog post:

  1. 1099C income must be reported on your tax return
  2. You may qualify for some type of exclusion so that some (or maybe even all) of it won’t be taxable

Taxable Income for Students

August 31, 2012 by · Leave a Comment
Filed under: Taxable Income 
Study

Photo by sobriquet.net at Flickr.com

It’s back to college time and lots of students have employment on or off campus.  Here’s a rundown of what is and what isn’t taxable to students.

 

Scholarships and fellowships:  If you are a degree candidate, you can exclude from your income scholarship money used for tuition and fees, or for classroom books, fees, supplies or equipment.  If you use your scholarship for room and board, that’s taxable.  If you are not a degree candidate, then all of your scholarship or fellowship is taxable.  For example:  let’s say you received a scholarship for $40,000.  Your tuition is $32,000 and your room and board is $8,000.  $8,000 of your scholarship would be taxable.  (Of course, saving your receipts for your books and fees would reduce your taxable portion.)

 

Most students who receive scholarships are not going to be taxed on them, but every year I come across at least one student who received a free ride and wound up having some taxable income from it.  It’s just something you need to be aware of.

 

Fulbright students and researchers:  these follow the same rules as scholarships and fellowships.

 

Fulbright grant for lecturing or teaching:  this is a little different, it counts as a payment for service and that’s taxable.  You need to know the difference once you’ve got a Fulbright.

 

Pell Grants, Supplemental Educational Opportunity Grants, and State Grants:  these are not taxable as long as they are used for tuition.  I’ve seen cases where students get these grants and don’t go to school and go to school and use the money for something else instead.  (Okay, true story, one got a breast enhancement and went to work for Hooters.)  If you do that, the money will be taxed.  Your Pell Grant is for tuition!

 

Reduced tuition for school employees and their children:  this is not taxable to undergraduate students, but taxable to graduate students.  There is an exception for the graduate students though, if they perform teaching or research activities, then the reduced tuition is tax exempt.

 

Contest prizes:  If you win a prize but you don’t use it for education, then it’s taxable.  If it’s used for tuition and fees, then it’s not.

 

ROTC:  the subsistence allowance that you get paid in advanced training is not taxable, but the active duty pay you get is something like the summer advanced camp and is taxable.

 

Work study jobs count as wages and you should be getting a W2 for that work just like you would any other job.  That’s taxable income.

 

Self-employment:  this is really tricky because companies often hire college students for jobs but they’re not employees, they’re contract labor.  In a case like that you have to pay self employment tax.  Right now, that’s 13.3% of your income over and above and other income tax you might have to pay.  I see lots of students get burned at tax time because they didn’t know about that little rule.   It’s often called a 1099 job.  It’s okay to have a 1099 job, but just know there are extra taxes involved.  If you’re thinking about taking a contract labor job, check this site out for more information:  http://robergtaxsolutions.com/2010/09/employee-or-contract-labor/

Do I Still Have to Pay Taxes After I’m 65?

July 31, 2012 by · Leave a Comment
Filed under: Taxable Income 
Cape Horner

Photo by Dietmar Temps at Flickr.com

I need to make this very clear—there is no law that says persons over the age of 65 do not have to pay taxes.

 

But obviously there’s some false information out there because I keep hearing people say they don’t pay taxes because they’re over 65.  What’s worse is that I’m doing back tax returns for senior citizens who are in trouble because they believed that garbage.

 

Granted, things do change when you retire, but if you’re earning income, Uncle Sam wants you to pay taxes on it.

 

Now some people don’t make enough money to be required to file a tax return.  Many of those people are senior citizens.  I think that’s where the rumor about not having to pay started—some people don’t have to file because their income is so low they don‘t owe anything.  But if you’re newly retired, you still need to prepare your tax return to make sure.

 

Here are some things that seniors get into trouble for:

 

Social Security income:  most people think that social security isn’t taxable.  For many people it’s not, but if you have other income, that could kick you into a category where your social security is taxable.  If you’re preparing your own tax return, you need to include the social security income on your tax return.  The computer program will calculate if any part of it is taxed—but if you leave it off, the program can’t help you.

 

Pension income:  once again, many people think that their pensions aren’t taxable.  Many pensions have a portion that isn’t taxable, but a completely nontaxable pension is extremely rare.  Your pension must be reported.

 

Odd job—self employment income:  Often seniors retire from their main job, and they’ll take on a small part-time job someplace just to get out of the house or to help out a friend who owns a business.  They’ll receive a form 1099MISC for the pay.  Under normal circumstances, the income would be small enough that they wouldn’t have to file, but if you have over $400 of self employment income—you’re required to file a return and pay self employment tax.

 

Stock transactions:  Seniors tend to draw from their investments when they retire.  As you draw funds from your mutual fund—you’re selling the shares.  Let’s say you draw $10,000 out of your mutual fund—the IRS will receive information that says you made $10,000 from selling those stocks.  As far as the IRS is concerned—you need to be taxed on that $10,000, plus that will probably kick you into having your social security be taxed as well.  But the truth is, you didn’t make $10,000 on that stock transaction—you may have even lost money—that’s why it’s so important to file your return so the IRS knows you don’t owe as much as they think you do.

 

The biggest problem with not-filing your tax return is that it takes the IRS a few years to catch the problem.  So by the time you get your IRS letter, they’ve already attached a “failure to file” penalty of 25%, and “failure to pay” penalty of up to 25%, and they’ve added interest on top of that.

 

So make sure you file your tax returns after you retire.  I recommend filing every year, even if you don’t owe and even if you’re not required to file.  It protects you from the failure to file penalty in the event the IRS “finds” something later.

 

Bottom line—you’re never too old to pay taxes.

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