As the economy moves closer to (or deeper into, depending on who you believe) recession, the number of credit card holders who will obtain reductions in their credit card debt from the issuer is likely to increase. Those debtors will eventually learn that the discharge of debt is taxable to them.
Section 108 of the Internal Revenue Code provides that such income will not arise in certain specified situations, including a discharge in a Title 11 bankruptcy, when the debtor is insolvent, when the debt is qualified farm indebtedness, when the debt is qualified real property business indebtedness, or when the debt is qualified principal residence indebtedness.
A recent Tax Court case highlights the creative arguments raised by taxpayers to come within Section 108 when the taxpayer doesn't fit within any of the above exceptions. In shooting down 2 taxpayer theories, it is evident that taxpayers should not expect any leniency from the IRS or the Tax Court on these issues.
The taxpayer first tried to use Code Section 108(e)(5). That provisions avoids debt discharge income where the buyer of property negotiates with the seller/creditor for a discharge of all or part of the purchase money indebtedness. The resulting discharge of indebtedness is characterized not as taxable income but in effect as a retroactive reduction of the purchase price. However, in this case the credit card company was found not be a seller of property, so the provision was held not to apply.
The taxpayer then tried to claim that the case of Earnshaw v. Comm., T.C. Memo 2002-191 stands for the proposition that the discharge of interest on debt is not income to the debtor. The Tax Court disagreed, finding that the case only applied to reductions in debt due to a bona fide dispute about the amount of the debt involved. While not discussed in the case, if the interest payment would have been deductible to the debtor, then Code Section 108(e)(2) would then have avoided debt discharge income to that extent. This provision avoids debt discharge income on debt that would be deductible if actually paid by the debtor. Presumably, the taxpayer in the Tax Court case could not use that provision because the expenses were personal, nondeductible expenses so that interest relating to their purchase would not be deductible.
Ancil N. Payne, Jr., et ux. v. Commissioner, TC Memo 2008-66