Does Issuance of Form 1099-C Dissolve Debt?
Compliments of Parker's Federal Tax Bulletin: May 23, 2013:
"A married couple defaulted on a loan secured by real estate. The bank that sold the property and had held the mortgage issued the couple a Form 1099-C, Cancellation of Debt, for the difference between what was owed and what the property was sold for. The couple included the amount in income and was surprised when, several years later, the bank tried to recoup the money the couple had reported as income, based on the Form 1099-C issued by the bank. In going after the couple, the bank was relying on previous court decisions that said the Form 1099-C did not necessarily discharge the debt. Luckily for the taxpayers, a bankruptcy court, in In re Reed, 2013 PTC 105 (Bankr. E.D. Tenn. 5/14/13), rejected the prior court decisions and held that the IRS's interpretation that the filing of a Form 1099-C does not prohibit further collection of a debt was unreasonable and not entitled to deference when the debtor has relied on the Form 1099-C and included the discharged or cancelled debt in gross income.
In 2008, William and Debbie Reed executed a promissory note for $304,000 in favor of First Tennessee Bank (First Tennessee). The note was secured by real property. In 2010, the Reeds defaulted on the note and First Tennessee foreclosed its lien and sold the property. At that time, as reflected on the Form 1099-A issued by First Tennessee to the IRS, the difference between the value of the property and the outstanding principal balance of the Reeds' loan was $5,074. First Tennessee also filed with the IRS, and sent to the Reeds, a Form 1099-C, which stated that the $5,074 was cancelled in 2010. Based on the Form 1099-C, the Reeds included the $5,074 as other income on their 2010 Form 1040 as cancelled-debt income.n 2011, First Tennessee Bank filed a lawsuit against the Reeds seeking to recover $12,075, representing the $5,074 principal balance and interest due under the promissory note after foreclosure, plus attorneys' fees and collection costs. Upon the Reeds' failure to respond, First Tennessee Bank filed a Motion for Default Judgment, at which time the principal and interest had increased to $12,307 and attorneys' fees and collection costs totaled $6,729. On January 5, 2012, the Reeds filed for Chapter 13 bankruptcy case and First Tennessee dropped the Motion for Default Judgment. The bank then filed a Proof of Claim in the Reeds' bankruptcy case for $18,824, representing principal and interest in the amount of $11,773, attorneys' fees and collection costs in the amount of $6,729, accrued interest in the amount of $323, and interest as it continued to accrue from January 6, 2012, at a rate of $0.94 per diem, in accordance with the promissory note. The Reeds objected to the bank's claim and, in November 2012, the court scheduled a hearing. The dispute was based solely on whether the Form 1099-C provided to the IRS, which required the Reeds to list the $5,074 of cancelled-debt income as part of gross income on their tax return, constituted a cancellation or discharge of the deficiency balance such that the Reeds no longer owed any obligation to First Tennessee under the promissory note.
Although the bankruptcy court said it generally agreed with the basic assessment that the IRS requires financial institutions to issue a Form 1099-C as a reporting requirement, it disagreed with the other courts that the IRS information letters cited by many courts were determinative as to the issue at hand, finding that the language of Reg. Sec. 1.6050P-1 itself was open to interpretation. On the one hand, the bankruptcy court said it recognized that the IRS's interpretation of the regulations may be entitled to deference. On the other hand, the court noted that an agency's interpretation of what Congress intended is entitled to deference only when a statute is ambiguous and the implementing agency's construction is reasonable, even if the agency's reading differs from what the court believes is the best statutory interpretation. It could not be discounted, the bankruptcy court stated, that the IRS's interpretation relied on by First Tennessee and other courts, which was based entirely on statements within the cited information letters concerning how the IRS views a Form 1099-C, directly conflicts with the Internal Revenue Code and the fact that cancellation-of-indebtedness income is included within a debtor's gross income. Cancellation of debt or COD, the court said, is a term that is interchangeable with the term discharge of indebtedness. For COD income to occur under Code Sec. 61(a)(12), the court noted, the taxpayer must have been discharged from a liability. According to the court, debt is considered discharged the moment it is clear that it will not be repaid, and determining when this moment occurs requires an assessment of the facts and circumstances surrounding the likelihood of repayment. Any identifiable event that fixes the loss with certainty may be taken into consideration. The court concluded that the IRS's interpretation that the filing of a Form 1099-C does not prohibit further collection of an indebtedness against a debtor was unreasonable and not entitled to deference when a debtor has, as required by the Internal Revenue Code, relied on the Form 1099-C and included the discharged or cancelled debt in gross income for the purpose of determining the debtor's taxable income. According to the bankruptcy court, it is inequitable to require a debtor to claim cancellation-of-debt income as a component of his or her gross income and subsequently pay taxes on it while still allowing the creditor, who has reported to the IRS and the debtor that the indebtedness was cancelled or discharged, to then collect it from the debtor. Cancellation-of-debt income, the court said, is not required to be reported to the IRS unless one of the express identifiable events occurs. The court found that if a financial institution has filed a Form 1099-C with the IRS, cancellation or discharge of a debt has, in fact, occurred. As a result, the bankruptcy court held that the $5,074 reflected on the Form 1099-C was discharged or cancelled, such that the Reeds were no longer indebted to First Tennessee for that amount. While noting that it was adopting the minority view, the court said that in the interests of justice and equity, it was the proper view. However, the bankruptcy court also held that the other amounts owed to First Tennessee (i.e., the interest, collection costs, and attorney's fees), which were not required to be reported under Code Sec. 6050P, and had not been reported on Form 1099-C, were still due and owing."