Don't Mess With Taxes

Debt is a terrible burden for many.

Sometimes, though, erasure of the debt is not a good thing.

That's the case for folks who, according to a story in today's New York Times, have received notification from banks that the lenders have forgiven the amounts the debtors owe.

The problem is that in many cases the loans no longer exist. The owed amounts were already disposed of, in some cases through bankruptcy.

The bank actions, however, now mean that the Internal Revenue Service will get notice that the former debtor has forgiven debt. Taxable forgiven debt.

Forgiven debt generally is one of those terrible tax surprises. Uncle Sam considers the amount that the lender erases from the books as income to the person who owed the debt. 

Certain loans are excepted. Under the Mortgage Forgiveness Debt Relief Act enacted in late 2007 and extended through 2012, taxes aren't due on the portion of a mortgage that is partly or entirely forgiven when the lender restructures the loan or the property goes into foreclosure.

But now, reports Gretchen Morgenson, some banks are forgiving debts on previously discharged debts.

As part of the "we really screwed up your mortgage" settlement in February between the U.S. government and five of the nation's big banks, the lenders agreed to pay $25 billion to settle claims. The carrot part of the deal was an offer by Uncle Sam to give the participating financial institutions credits against the amounts they agreed to pay.

The credit collection portion of the deal has begun in earnest, with banks writing off old loan amounts right and left.

To the dismay of former customers, this financial goodwill is way too late to do them any good because they no longer owe the amounts. The debts have been discharged. That means it is no longer the banks to forgive.

But the banks' ostensible forgiveness means that the IRS will be getting notice that the former debtors have received income via the discharges of phantom debt. 

And it will be up to the individuals to explain that they don't owe taxes on the not-the-banks-to-forgive debt.

Thanks once again, big banks, for nothing.

Bank explanations, sort of: The banks told Morgenson that the blanket issuance of loan forgiveness was not prompted by the promise of credit from the federal government.

Yeah, right.

And Morgenson reports that she got "the same unsatisfying answer" from Chase and Bank of America officials as to how they could forgive debts that no longer existed.

The banks also were a little sketchy about why they didn't write letters specifically tailored to each borrower's situation, although Chase and Bank of America have taken some steps to clear up things.

Still, folks who receive notice of forgiven debt that didn't actually exist for the banks to forgive will have to deal with any potential tax consequences.

A recent U.S. Tax Court ruling that forgiveness of uncollectable zombie debt is not taxable could be helpful to the bank customers getting these phantom debt letters.

But as has been the case since the banking mortgage debacle came to light with the 2008 bailout, it will once again be up to affected individuals -- and taxpayers -- to clear up confusion caused yet again by banks' questionable practices.

• Trading credit card debt for a tax bill
• Foreclosure's costly tax implications
• Will your state make you pay up on forgiven federal mortgage debt?