If a lender makes a loan to a borrower, but ends up having to discharge the debt due to the borrower’s bankruptcy or other qualifying trigger, then as far as the IRS is concerned, the discharged amount wasn’t free money to the borrower – it’s considered taxable income. How and when that discharged amount gets communicated to the borrower as well as the IRS can be a little complicated, but it’s about to get less so, if a recent IRS proposal goes through.
Here’s the scoop on what is causing the confusion and how the IRS proposes to clear matters up.
First, some background. Section 6050P of the IRS Code requires that discharged debt be included in the debtor’s gross income for tax purposes. The IRS is generally alerted that a discharge of debt of $600 or more in a given calendar year has occurred when a financial institution files the informational 1099-C Discharge of Indebtedness form.
One of These Things is Not Like the Other
The IRS Code identifies eight specific identifiable events that trigger the requirement to file a 1099-C. These events are:
- A discharge of indebtedness under title II of the U.S. Bankruptcy Code;
- A discharge that occurs when a debt is rendered unenforceable in a receivership, foreclosure, or similar proceeding in a federal or state court;
- A discharge due to expiration of the statute of limitations for collection of a debt or expiration of the statute of limitations for filing a claim or deficiency judgment;
- A discharge based on the election of foreclosure remedies that bar the financial institution from pursuing the indebtedness;
- A discharge based on a probate or similar proceeding that renders the debt unenforceable;
- A discharge that occurs when a financial institution and its debtor agree to discharge the debt at less than full consideration;
- A discharge by the financial institution due to an established business practice or internal institution policy; or
- The expiration of a 36-month non-payment testing period.
The first seven triggers are based on an actual discharge of the debt. The last item, however, is not and, as a result, has been a source of confusion for both debtors and financial institutions. In addition, the IRS’s ability to enforce collection of taxes on the reported amount can be undermined if the actual discharge occurs in a year other than the year in which the 1099-C is filed. This is often the case when the 36-month, non-payment testing trigger is applied.
Financial institutions have struggled with identifying when the 36-month non-payment period has tolled as it requires a determination of whether the institution has received any payment on the debt and whether it has engaged in any significant bona fide collection activity during any of those calendar years. Debtors who receive a 1099-C as a result of a 36-month non-payment testing period may not understand that they do not have to include the debt amount as income if the debt has not actually been discharged by the creditor at that time.
As a result, the IRS has issued a proposed rule that would eliminate the 36-month non-payment test period as a trigger for filing a 1099-C Discharge of Indebtedness. This would leave us with the other seven factors noted above, all of which are triggered by an actual discharge of the underlying debt.
While it seems unlikely that there would be significant objections to the change, it is important to remember that the change is still only a proposal. Comment period closes Jan. 13, 2015. Until the rule is finalized with an effective date in place, the 36-month non-payment trigger remains in effect. Confusing or not.