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Canceled debts will lead to IRS tax

If canceled debt is reported, you will have to pay

By

To Her Credit
To Her Credit, Sally Herigstad
Sally Herigstad is a certified public accountant and the author of "Help! I Can't Pay My Bills: Surviving a Financial Crisis" (St. Martin's Press, 2006). She writes "To Her Credit," a weekly reader Q&A column about issues involving women, credit and debt, for CreditCards.com, and also writes regularly for MSN Money, Interest.com and Bankrate.com, and has guested on Martha Steward Radio and other programs. See her website SallyHerigstad.com for more personal finance tips and free budgeting worksheets.
Ask Sally a question, or read her previous answers in the To Her Credit archive
Question for the CreditCards.com expert

Dear To Her Credit,
I have an old credit card debt from 2002. When the collector called today, I told him the debt was too old to collect. (I live in Oklahoma.)

He replied that if he wanted, he could send a form to the IRS and then I would have to pay taxes on the money owed. Is that true? What good is a limit on the time a collector can come after me if I have to pay tax on the amount of the old debt anyway? -- Judy

Answer for the CreditCards.com expert

Dear Judy,
I'm sure the collector was disappointed to discover that you knew about the statute of limitations on credit card debt. You have to give him credit for making a quick recovery, however, by bringing up the tax you might owe. He doesn't give up easily!

The first issue is whether the debt is really too old to collect. In Oklahoma, the statute of limitations period is three years. That's one of the shortest periods in the country. As of 2009, you're well beyond the three-year period for a 2002 debt.

Remember, though, just because the debt was from 2002 doesn't mean the statute of limitations started in that year. Did you make the last charges on your card in 2002? Or was 2002 the last time you made a payment or otherwise acknowledged the debt? The statute of limitations period may begin the date the last payment was due or the date the account became delinquent, or even six months after the last payment. It depends on your state laws. And if you acknowledge the debt or make even a small payment after the time period starts, it resets and starts all over!

Assuming you haven't made a payment or in any other way restarted the statute of limitations, your three years is probably up. Unfortunately, that doesn't mean you can just ignore collectors. Here are some things to consider:

  • If the debt is legitimately yours, you may want to pay it, for your own conscience's sake.
  • Creditors can still legally try to collect from you even after the statute of limitations expires. In fact, they are under no obligation to try to determine the statute of limitations period for you.
  • The unpaid debt still shows up on your credit report for seven years. That alone motivates many people to pay old debts. And don't think that once an account is delinquent, you might as well leave it unpaid on your record. A debt that was delinquent but is now paid off does far less damage to your score than an old, unpaid debt.
  • When creditors sue you for collection, it's up to you to prove that the statute of limitations has run out. If you get court notices, pay attention! Get legal help, if necessary.
  • If the creditor cancels the debt, as the collector told you, you probably have to pay tax on the amount canceled. The creditor can send a Form 1099-C to you and to the IRS showing cancellation of debt.

The collector who told you he could send the IRS a form and you'd have to pay taxes may be bluffing. He can't send the notice unless he actually cancels the debt, and why would he do that?

Even if you do have to pay the tax on the amount of the old debt, you're still a lot better off paying the tax than having to pay the entire debt. For example, if you're in the 25 percent tax bracket and a creditor reports a cancellation of debt for $10,000, you'll owe about $2,500 in taxes. (It's never quite that simple, but it's close.) I'd rather pay $2,500 than $10,000 any day.

Take care of your credit!

See related: Statute of limitations on credit card debt, What is debt reaffirmation, 9 questions to ask before you reaffirm an old debt, Beware of the tax bite that follows debt resolution

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"Opening Credits"

Published: January 23, 2009


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