Credit Card Defaults Should Not Result in DOI Income

A few weeks ago I posted an entry titled The Hidden Problems with Forgiven Credit Card Debt that explained how forgiven credit card debt is actually considered taxable income in the eyes of the IRS. In the entry I explained how this issue has created unnecessary financial hardship for many, and it looks like the issue is finally gaining more attention. Yesterday I came across an interesting study by Richard C.E. Beck of New York Law School via the Tax Professor. Beck’s publication is titled “The Tax Treatment of Cancelled Interest and Penalties on Consumer Debt” and it explains why forgiven debt is taxable, and what can be excluded. Check out the abstract below, or click here to download the full PDF.

When defaulted credit card debt is cancelled, only the forgiven principal is taxable as COD income. Cancelled interest and penalties is not taxable income unless the items would have been deductible, and thus the Tax Court's recent decisions in Payne v. Commissioner, T.C. Memo. 2008-66, and Hahn v. Commissioner, T.C. Memo. 2007-75, are erroneous. Cancelled penalties are not taxable because the borrower has received no loan proceeds, and cancelled interest is not taxable because it is in effect simply a price adjustment for the use of money. Currently required 1099-C reporting is defective because it does not require splitting out cancelled principal. Taxpayers are being unjustly overtaxed because forgiven credit card debt often consists of amounts of interest and penalties which are equal or greater than the amount of principal.