As we’ve discussed previously, when taking a bad debt deduction for a loan you’ve made that will never be repaid, timing is everything. It’s just as critical to be able to prove when a loan became worthless as it is to establish the loan’s worthlessness.
But what of the tax consequences to the borrower? If the lender recognizes a bad debt deduction, presumably the borrower should recognize corresponding cancellation of indebtedness income (COD). As the Tax Court proved on Monday afternoon, identifying the correct tax year in which the debt was forgiven is equally important in fixing the recognition of income to the borrower.
David Stewart rang up significant credit card debt during the early 1990s, presumably on Reebok Pumps and Nirvana tickets. At some point between 1994 and 1996, Stewart stopped paying down the balance, and the lender , MBNA, formally charged off the debt in late 1996.
Soon after, a second debt collection company purchased Stewart’s debt from MBNA, before in turn selling it to Portfolio Recovery Associates (PRA) in 2007. Despite the fact that collection on the debt was legally barred by the statute of limitations, PRA began to attempt to collect from Stewart using automated letters and phone calls.
Stewart wrote to PRA, demanding they cease collection activities. They complied, closing the books on the debt and issuing Stewart a 1099-C for $8,500 in 2008. On his 2008 tax return, Stewart failed to report the COD income. The IRS sent a notice of deficiency, requiring Stewart to include the debt forgiveness in his taxable income.
While it is a common principle of tax law that the forgiveness of a debt is an accession to wealth resulting in taxable income to the borrower,as discussed previously identifying the year in which a debt is forgiven is essential to the timing of the income.
In general, a debt is deemed discharged the moment it becomes clear it will never be repaid, a determination that is dependent on all the facts and circumstances surrounding the forgiveness.
In the immediate case, the Tax Court fixed the date the credit card debt became worthless by looking to Treas. Reg. §1.6050P-1(b)(2)(iv), which provides that an identifiable event has occurred fixing a debt’s worthlessness if during a tax year, the lender has received no payments from the borrower over the previous 36 months.
The Tax Court noted that Stewart defaulted on his credit card during 1994 and that the original lender wrote off the debt in 1996. Because Stewart made no further payments on the debt after 1996, the court concluded that the 36-month testing period expired in 1999. As a result, there was an identifiable event in 1999 indicating that the debt was in fact forgiven in 1999, rather than 2008.
Under the regulations, the presumption that the debt was forgiven in 1999 could be rebutted in two ways:
First, if the lender could establish that it engaged in significant, bona fide collection activities after the identifiable event, the debt would not be treated as having been forgiven. Because for these purposes automated mailings and phone calls do not constitute “bona fide collection activities,” however, the presumption that Stewart’s debt was forgiven in 1999 could not be overcome.
In addition, if during the January following the expiration of the 36-month testing period, facts and circumstances indicate that the debt hadn’t been discharged, the debt would remain intact. One factor indicating that the debt hadn’t been discharged is the sale of the debt by the lender.
In the immediate case, it could not be established when the original lender sold Stewart’s debt. Because it could have been sold well after 1999, the sale of the debt could not be proven to have occurred within the requisite 31-day period beginning on January 1, 2000. Thus, the presumption that the debt was forgiven in 1999 again could not be overcome, forcing the Tax Court to conclude that Stewart’s debt was forgiven in 1999, rather than 2008. Because the 1999 tax year was closed by statute, Stewart was not required to recognize any taxable income related to the forgiveness.
Perhaps most importantly to taxpayers, the Tax Court held that the issuance of a 1099-C in 2008 was not dispositive of a discharged debt. Though a 1099-C is an indication that a debt has been forgiven, the court concluded that the true forgiveness occurred years earlier in 1999, when a 36-month period concluded with no payments on the debt.
 Before considering the exclusions available under Section 108
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