Gail-

My sister passed along a recent column in which you wrote that if you owe a debt to someone and that debt is forgiven, you have to report that as income and pay tax on it.

I had my truck repossessed by the dealer finance company because I couldn’t keep up with the payments after I quit my job. They threatened to take me to court, but when I told them I was unemployed, they let me off the hook for the rest.

Are you telling me I’m going to have to pay income tax on the balance that was due on the loan even though I no longer have the truck?

Jason

Dear Jason,

Probably. At the end of the year, a lender who has written off a debt that can’t be re-paid is required to send the borrower Form 1099-C: “Cancellation of Debt.”

Do not throw this away! A copy of the form is also sent to the Internal Revenue Service, which will compare the information against what you report on your 2007 income tax return.

The first thing you want to do when you receive Form 1099-C is to check the accuracy of the values it lists. Among other things, these will include the outstanding loan balance and the fair market value of the property. This is generally- though not always- the price for which it was eventually sold.

If you disagree with any of the values on the 1099-C, contact the lender immediately so a corrected form can be issued. Be prepared to document why you are disputing a particular amount.

In essence, the amount you still owed on the loan, minus the truck’s fair market value, will show up in Box 2 of Form 1099-C. You will enter this amount on Line 21 of Form 1040 for “Other Income.”

If you neglect to report this, you can expect the IRS to contact you for under-reporting your income.

The obligation to pay income tax on a canceled debt is based on a 1931 Supreme Court decision (1) and lower courts have cited the case ever since. In a 2005 decision involving a similar situation as yours, the Tax Court explained “the general theory is that to the extent that a taxpayer has been released from indebtedness, the taxpayer has realized an accession (i.e. an increase) to income because the cancellation of indebtedness effects a freeing of assets previous offset by the liability arising from such indebtedness.”

To paraphrase the IRS, when the finance company gave you the money to purchase your truck you didn’t have to pay income tax on this at the time since “you had an obligation to re-pay the lender.” When that obligation is forgiven, you no longer have to pay the money back, so “the amount you received as loan proceeds is reportable as income.”

If the finance company sold your truck after it was re-possessed this reduces the amount you must report when you file your taxes. In essence, the sale of the vehicle re-paid some of the amount of the loan you still owed.

Let’s say you got a loan for $15,000 to buy your truck. After making 18 months of payments, you bring the loan balance down to $12,000 — and then default. The finance company repossesses the truck and sells it for $5,000 at a used vehicle auction. Now your Box 2 on Form 1099-C will read “$7,000.”

It may seem unfair, but the government views this as: for 18 months you had the use of $7,000 that you never paid income tax on. Or, looking at this another way, the use of the truck for a year and a half ended up costing you $10,000— the $3,000 you paid, plus the $7,000 that was forgiven.

I’d say that was a pretty expensive vehicle.

In cases like yours there are certain circumstances in which a canceled debt is not subject to income tax, but, frankly, most of them make paying the tax the preferred outcome.

For instance, if you declare bankruptcy and the bankruptcy court “discharges” your debt, you won’t owe income tax on the forgiven amount. Of course, bankruptcy means your credit rating will be trash for ten years.

Another exception is if you are legally insolvent when the outstanding debt is canceled. This is a bit tough to prove since you have to show that the total of all your outstanding debts exceeds the total of all your assets. The IRS advises that taking this route “can be fairly complex” and recommends you work with a tax professional.

The same concept of reporting a canceled debt as income applies in other cases, like when a credit card bill is written down or off.

It’s unfortunate that this happened to you. A loan is a legal obligation and default is taken very seriously. When someone knows they are going to have difficulty paying a debt, it’s critical they contact the lender and try to work out new terms that will satisfy the needs and goals of both parties. Default should be a last resort.

Hope this explains things,

Gail

(1) United States v. Kirby Lumber Co., 284 U.S. 1,3 (1931)

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.