When does cancellation of indebtedness take place?
Taxpayer Says: Though Form 1099-C was received in 2006, the debt cancellation occurred in an earlier year. No cancellation of indebtedness income is reportable on the 2006 income tax return.
Internal Revenue Service Says: The lender engaged in substantive debt collection activity through 2006. The debt was cancelled in 2006 and should be reported on the 2006 tax return.
From Internal Revenue Code Section 61(a)(12): In general, the term “income” as used in the Internal Revenue Code means income from any source, including income from the discharge of indebtedness.
From Federal Tax Regulation 1.6050P-1(b)(2)(iv): There is a rebuttable presumption that an identifiable event has occurred during a calendar year if a creditor has not received a payment on an indebtedness at any time during a testing period ending at the close of the year. The testing period is a 36-month period increased by the number of calendar months during all or part of which the creditor was precluded from engaging in collection activity by a stay in bankruptcy or similar bar under State or local law.
From Cozzi v. Commissioner, 88 T.C. 435, 445 (1987): The moment it becomes clear a debt will never be repaid, that debt must be viewed as having been discharged. The determination of whether discharge of indebtedness has occurred is fact specific and often turns on the subjective intent of the creditor as manifested by an objectively identifiable event. Moreover, a mere bookkeeping entry by a creditor does not result in discharge of indebtedness income.
From Owens v. Commissioner, T.C. Memo. 2002-253, affd. in part, revd. in part and remanded 67 Fed. Appx. 253 (5th Cir. 2003): The issuance of a Form 1099-C is an identifiable event, but it is not dispositive of an intent to cancel indebtedness.
THE CAUSE OF THE DISPUTE
If a lender forgives a debt you owe, you have income that must be included on your tax return, unless you qualify for an exception. When the amount of the debt forgiveness exceeds $600, the lender is required to send you an information return, Form 1099-C, reporting the amount.
Debt is considered discharged when an identifiable event occurs. For instance, the lender sending you Form 1099-C is an identifiable event.
Other specific identifiable events are listed in the federal tax regulations, including the expiration of a three year “non-payment testing period.” When a lender hasn’t received a payment on a debt during a three year time period, it’s presumed an identifiable event occurred, unless the lender engaged in bona fide collection activities.
The question in this case is whether the testing period expired prior to the issuance of Form 1099-C.
The taxpayer signed a four year property lease in 1996. She stopped making payments on the lease in 1998. In December 1998 she sent a letter to the lender, a government agency, explaining her inability to pay.
The agency acknowledged the letter in 1999, and sent a demand for payment for the past due amounts, plus interest. The agency sent more letters in the following months, then kicked the debt collection up to the next level of governmental bureaucracy. Additional letters were sent to the taxpayer from that agency during 1999.
In 2001, the second agency kicked the debt collection up one more level, to a third agency, and in 2004 the third agency referred the debt back to the first agency as uncollectible. The debt write-off was authorized in 2005, and Form 1099-C showing $263,587 of debt forgiveness was issued in 2006.
The taxpayer did not report the debt forgiveness on her 2006 tax return. She argued the actual discharge occurred in an earlier year. Since she received no correspondence after 1999, she believes that under the three year presumption, debt discharge occurred in 2002, not 2006.
The IRS says that though the taxpayer received no correspondence, the timeline of government activity shows collection activity continued from 1999 through 2006, and the discharge took place in 2006. The income should have been reported on the taxpayer’s 2006 tax return.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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