Debts That Have Been Charged Off


What is a charge off?

A charge-off is an accounting procedure for tax purposes used by the creditor where an uncollectible debt or charge-off is reported as a loss for the creditor. Creditors typically write off or charge off a debt if there has been no payment on the account for more than 180 days or six months.

Can a creditor still collect on a debt that has been charged off?

Charge-off does not mean the debt is extinguished or forgiven and no longer owed by the account holder. The creditor can and often does attempt to collect the debt with either an in-house collection program or more commonly with a third-party debt collection service unless the Statute Of Limitations has expired on the debt, long after it has been charged off. Because the original contract for the debt, such as a loan or credit card agreement, was not honored, the account balance can be requested paid in full. A creditor will sometimes accept a partial payment of the debt and the account will be reported as "settled charge-off".

Tax consequences of settling a charge-off

If you borrow money from a commercial lender and the lender later forgives or cancels the debt, depending on the circumstances, you may have to include the canceled amount in income for tax purposes. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to the IRS and to you on a Form 1099-C, Cancellation of Debt.

Here is a example that is very simplified. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which normally is taxable income to you.

Is Cancellation of Debt income always taxable?

Not always because there are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

1) Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.

2) Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.

3) Insolvency: All or some of the canceled debt may not be taxable to you if you are insolvent when the debt is canceled. You are insolvent when your total debts are more than the fair market value of your total assets.

4) Non-recourse loans: A non-recourse loan is a loan for which the lender's only remedy in case of default is to repossess the property used as collateral or being financed. That is, the lender can't pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure doesn't result in cancellation of debt income. However, it may result in other tax consequences.

5) Certain farm debts: Your canceled debt is generally not considered taxable income if you incurred the debt directly in the operation of a farm, the loan was owed to a agency or person regularly engaged in lending, and more than half your income from the prior three years was from farming.

The charge-off will remain on your credit report for seven years plus 180 days from the date of the first nonpayment under the Fair Credit Reporting Act.