This post was originally published on Forbes Mar 6, 2015If you owe somebody money and then you don't have to pay it back that can create taxable income for you. It is called either income from the discharge of indebtedness or cancellation of debt (COD). The rules about when you can exclude COD from taxable income are in Code Section 108. Timing is important. If you are bankrupt or insolvent when the debt is discharged you can exclude it from your taxable income (You may have to adjust your basis in property). The other way that timing can be important is that if you miss reporting COD when it happens and three (or maybe six) years go by, you are home free.
Between January 1995 and September 1997 FEMA sent petitioner eight letters and left four voicemail messages seeking to collect the amount due. When petitioner did not make any payments during that period, FEMA ultimately prepared a Claims Collection Litigation Report (CCLR) in October1997 and referred petitioner's account to the Department of Justice (DOJ) for judicial enforcement of its claims. The CCLR stated that petitioner's default date was January 27, 1995, and that the Government's claim would expire on January 27, 2001, six years after the original default. This was consistent with the statute limiting the time for the Government to commence an action to recover the debt. 28 U.S.C. sec. 2415 (2006) (discussed below). The DOJ never commenced any suit or initiated any other action to recover the funds.
In February 2008, after petitioner's account had remained dormant for over 10 years, FEMA mailed petitioner a Form 1099-C, Cancellation of Debt, reporting discharge of indebtedness of $6,297 for 2007. Such amount represented the principal amount initially distributed to petitioner in January 1994 plus the interest and penalties accrued through 2007. Petitioner did not report any COI on her timely filed Federal income tax return for 2007.
The practice point here is to not ignore out of the blue 1099's as this one must have been. Don't ignore, them but don't reflexively report the income either. There is a decent chance that there might be an argument that the 1099 is wrong at least as it applies to the year in question. If you can come up with something to hang your hat on, report the amount, but then back it out on another line with an explanation. That may keep the computer happy and be the end of the story.