Beware of Credit Card Settlements

If you have a high outstanding balance on your credit card, you may be able to negotiate with the credit card company for a reduced settlement. While such a settlement can save you thousands of dollars in interest and help to restore your credit rating, it can cost you tax dollars.

How a settlement works

Say you owe $20,000 to a major credit card company. It may agree to accept $5,000 as a full settlement of the account balance. Once you make this payment, the company will issue you a Form 1099-C reporting the amount you didn’t have to pay as “discharge of indebtedness income.” This income usually is taxable to you.

In one recent Tax Court case, a couple who negotiated just such a settlement with MBNA argued that the arrangement did not produce any income; it was merely a retroactive reduction in the interest charged. They analogized it to the situation where a property seller who gives seller financing later reduces the outstanding balance; this is treated as a reduction in the purchase price.

The court, however, explained the difference here. The parties to a credit card are that of debtor and creditor; there is no sale of
property. Thus, any reduction in the outstanding balance is a discharge of indebtedness.

Exceptions to recognizing income

Discharge of indebtedness income for personal credit card debt (called “nonbusiness debt”) does not have to be recognized if the debtor is:

• Bankrupt (Title 11).
• Insolvent (current liabilities exceed current assets).

A debtor who excludes the discharge from income must reduce the basis of nondepreciable (personal) assets, as explained on Form 982. The basis reduction is the smallest of (a) the basis of nondepreciable property, (b) the amount of nonbusiness debt that is excludable, or (c) the excess of the aggregate bases of the property and amount of money held immediately after the
discharge over aggregate liabilities immediately after the discharge. Attach this form to the income tax return for the year of the discharge.

Note: There is a special break for homeowners who receive discharge of indebtedness income on a mortgage to buy, build, or substantially improve their main home. No income is reported for any discharge in 2007, 2008, or 2009. The basis of the residence must be reduced by the amount of discharge that is not taxed.

Source: Payne, Jr., TC Memo 2008-66