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Old debt, uncollectable and not taxable

Receiving one of the various 1099 forms usually means that you also received taxable income.

Note the word "usually."

A recent Tax Court ruling in the favor of one debtor underscores the importance of knowing credit and tax laws.

And that ruling is why 1099 is the latest By the Numbers figure.

1099 income reporting forms

The specific 1099 involved in the Tax Court case was Form 1099-C, issued when a taxpayer has unpaid debt forgiven by the creditor. This information form is filed because such amounts generally are taxable income.

Read on to find out what happened to one man who got a 1099-C and then a bigger tax bill because of that form.

Rise of the zombie debt: Back in 1994 David Scott Stewart ran up credit card charges and two years defaulted on the bill. The card issuer, Maryland Bank National Association (MBNA), charged off the debt in 1996.

Fast forward to late 2007. That year Portfolio Recovery Associates (PRA) acquired Stewart's defaulted account and began trying to collect payments.

Stewart wrote PRA, pointing out that the state's debt collection statute had run out.

That's right. After a certain point, debts cannot be collected.

The statute of limitations on noncollectable debt varies from state to state, but according to the Federal Trade Commission the time limit is between three and 10 years. has a cool interactive map you can use to see the rules for your state.

Sometimes, though, this dead debt comes back to haunt debtors. That's why it's often referred to a zombie debt.

Zombie debt also is why you need to know what your state's laws are regarding collection efforts of old unpaid bills to finally finish it off.

Send a cease and desist letter to the collector explaining that the time allowed to collect the debt has expired. If the collector persists and ultimately files suit to collect the too-old debt, be sure to show up in court with evidence that the statute of limitations for collection purposes has expired.

Stewart informed PRA that his debt was beyond the statute of limitations. The collection agency then ended its efforts to get the money.

But it didn't stop there.

Taxable canceled debt...or not: PRA also issued Stewart a Form 1099-C, Cancellation of Debt, which reported $8,570 in cancellation of debt income for taxable year 2008. (See, we finally got back to the weekly number.)

The IRS also got a copy of the 1099-C for the canceled credit card debt and determined that for the 2008 tax year Stewart owed income tax of $2,138.

This is standard procedure. In most cases, when debt is canceled, the amount you don't have to pay is taxable income.

One exception that's gotten a lot of attention because of the horrid housing market mortgage debt canceled in connection with foreclosures. In some of these cases, the homeowners do not owe taxes on the forgiven debt.

Canceled debt also is not taxed in cases of insolvency or bankruptcy.

In the applicable cases, file Form 982 to let the IRS know why you're excluding the cancellation-of-indebtedness, or COI, income. You also might see this referred to as cancellation of debt, or COD, income.

Old untaxed COI income: And, according to the U.S. Tax Court, the canceled debt in Stewart's case was not taxable.

The IRS' argument was that Stewart's debt was discharged in 2008 when the Form 1099-C was issued by PRA.

Stewart said the debt was discharged back in the '90s when MNBA gave up on trying to get its money.

Tax Court Special Trial Judge Robert N. Armen, Jr. said a debt is discharged the moment it becomes clear that it will never be repaid. That said, determining that nonpayment moment is not precise.

Armen noted, however, that income tax regulations provide a list of eight "identifiable events" under which a debt is discharged for information reporting purposes; that is, when it's no longer necessary to let the IRS know of the canceled, and taxable, debt income.

One of those events is the expiration of a 36-month nonpayment testing period. In Stewart's case, that would have been in 1999.

So Armen determined that Stewart had no canceled indebtedness income in 2008:

"It appears from the record that PRA attempted to revive the defaulted account in an attempt to coerce petitioner, using automated mailing and automated telephone calls, to make voluntary payments to PRA despite over a decade of nonpayment and an expired limitations period. When PRA received petitioner's 2008 letter, the company immediately stopped its automated collection activity and issued Form 1099-C. We are not persuaded, however that the decision by PRA … was the first identifiable event indicating that petitioner's debt would never have to be repaid. Therefore, on the basis of the record and after a practical assessment of the facts and circumstances surrounding the likelihood of repayment, we hold that petitioners did not have any COI income from PRA in 2008."

The tax lesson to go along with the zombie debt lesson is that receiving a Form 1099-C on a discharged debt doesn't necessarily mean you owe tax.

If you happen to find yourself in a cancellation of debt situation where the amount is not taxable income (insolvency, bankruptcy or mortgage related debt forgiveness), you can file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

Or if you encounter a zombie debt/1099-C situation similar to Stewart's, Form 4598, Form W-2, 1098, or 1099 Not Received, Incorrect or Lost, could be the answer. This form isn't available online, but Steve Rhode provides a discussion of 4598 and erroneous 1099-C reports.

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