Asymmetrical Information - Megan McArdle

11.14.12

Debt and Taxes

What are the tax implications of forgiving America's enormous debt burden?

A little while back, a reader wrote in to "Ask the Blogger" to inquire as to my opinion of Rolling Jubilee, an idea that grew out of Occupy Wall Street.  Basically, the notion is that you buy up distressed debt for pennies on the dollar, and then cancel it.  I've been meaning to answer this, but haven't gotten around to it, so here goes: it seems like a fine idea, as far as it goes.  It's non-coercive, and it helps both creditors and debtors to move on with their lives, rather than staying chained to this largely unrecoverable debt.  

However, I would have added, there are limits to how far it goes, because debt cancellation is a taxable event, as Nick Summers just wrote in Businessweek.  If you cancel a $200,000 mortgage, that's treated as $200,000 worth of income to the borrower.  There are good reasons for this--otherwise, we'd all get our paychecks as "loans" that would then be "forgiven" and the government would have to fund itself by looking under the Senate couches for spare change.  

But the organization behind Rolling Jubilee, called Strike Debt, denies that this is so:  

Will the Rolling Jubilee have to file a 1099-C Cancellation of Debt form with the IRS?  

No. The Rolling Jubilee will earn no income from the lending of money and is therefore exempt from filing a Form 1099-C under the Internal Revenue Code Section 6050P.   

Felix Salmon is quite critical of Summers for not even looking at the Rolling Jubilee FAQ:  

In other words, there will not be any tax consequences to what Strike Debt is doing, on the perfectly legal grounds, as Worstall has found in the tax code, that “you do not have income from canceled debt if the cancellation or forgiveness of the debt is a gift”.  

To put it another way, the debtors will no more have to pay income tax on the forgiven debt than they would have to pay income tax if I gave them a gift of that money. What’s more, Strike Debt won’t report the cancellation to the IRS, and the debtor will probably not know that their debt has been forgiven. Given all that, the chances of the IRS coming after the debtor for income tax on the forgiven debt are exactly zero.  

Updates to Summers piece suggest that the FAQ was actually put up in response to what he wrote, so there was no way for him to look at it before.  More to the point, Felix's argument is wrong, at least for large gifts.  You cannot (legally) gift someone a sizeable sum without one of you paying taxes on it--either gift taxes, or income taxes.  The IRS has had a hundred years of people figuring out cute ways to avoid the income tax by calling "a large chunk of  money" something other than "income".  The odds that some wordsmith has discovered some novel semantic distinction that provides get-out-of-taxes-free card are very slim.  

Especially since if you do discover such a clever distinction, the tax court (the IRS basically gets its own legal system to handle disputes) is quite apt to rule that you're just saying that to get out of paying taxes, and order you to pay anyway.  

I've put a call into the IRS, but unfortunately, the IRS quite resolutely refuses to comment on individual cases, so I'm not sure I'll get much of a response.  I've also got feelers out to a few tax lawyers.  But the tax lawyers who Summers consulted seem quite sure of themselves:  it may be harder to catch you if they don't file a 1099-C, but that doesn't mean you don't owe the money.  

But is it actually true that being a 501(c)4 exempts you from filing a 1099-C?  I would be very surprised indeed to learn that it is, given that nonprofits have to file all the other sorts of 1099 forms if they pay interest or hire independent contractors.  And even if it is true, I'm pretty willing to bet that a 501(c)4 which makes explicit its plans to use that status help folks dodge taxes is probably not going to enjoy its 501(c)4 designation for very long. 

Said tax lawyers are also pretty dubious about the "it's a gift" strategy.

 Of course, even if I'm right, that still means that you can trade a large debt to a bank for a smaller debt to the IRS, and ceteris paribus, smaller debts are better than large ones.  But hold on before you get too excited, because in this case, ceteris is not paribus.  IRS debts are much harder to shed than bank debt--they can even survive bankruptcy.  And the IRS has considerably more collection muscle than Bank of America.  

Whether the IRS will treat this as a taxable event is, of course, a separate question from whether the IRS should treat it as a taxable event.  I'm inclined to think that they shouldn't--that either the IRS should laxly enforce this provision, or Congress should pass a law making this sort of charity explicitly legal.  It would be a good thing to do for people who are overindebted, and it would also be a good thing to do for the economy.  

On the other hand, I've reported on tax changes long enough to know that it probably isn't that simple: that in practice, it may be very difficult for the IRS to distinguish between legitimate charitable "jubilees" and tax avoidance scams, so they may legitimately decide that it's better not to allow them at all.  Since we already have a quite robust mechanism for debt forgiveness--it's called "the bankruptcy code"--it will be understandeable if the IRS declines to open up a large hole in the tax code in order to enable Rolling Jubilee to do its work.  And given the uncertainties, Rolling Jubilee should definitely get a ruling from the IRS before they start "gifting" people with hefty tax liabiliites.