Millions of American taxpayers have finished filing their annual tax returns. For many families, this exercise was a painful reminder of an aspect of their financial life they thought they had left behind: debt.
That is because the “other income” line of IRS Form 1040 asks whether a taxpayer has had debt forgiven in the last calendar year. That debt can include credit card, medical, and other unsecured debt, or, as President Joe Biden has noted, other types of debt such as student loan debt. As far as the IRS is concerned, debt that has been wiped off that family’s books is akin to a salary or hourly wages. If, for example, a family owed $50,000 in medical debt, but on their own or with a debt resolution provider, was able to reduce that sum to $10,000, the IRS would consider the $40,000 difference as income in their pockets.
In other words, as far as the federal government is concerned, resolving debt is the same as getting a bonus or winning the lottery. Eliminating debt is freeing, but it is certainly not the same as winning the jackpot.
This provision is unconscionable at a time when credit card interest rates have soared past 22%, credit card delinquencies are rising, and 41% of Americans hold medical or dental debt.
However, it will take congressional action to change the law. The American Association for Debt Resolution (AADR) believes Congress should evaluate changing the current law so that families struggling with debt are not hit with an unforeseen tax once they find financial freedom. That’s why we have requested that Congress’s Joint Committee on Taxation (JCT) tally exactly how much relief would come from eliminating this reporting requirement.
Other organizations have done their own calculations that demonstrate the significant burden that this single line of the 1040 form places on struggling borrowers. According to The Urban Institute, canceling $10,000 in debt would cost a taxpayer earning less than $122,000 about $2,400. Forgiving $50,000 in debt would cost a taxpayer $6,160.
For families facing a financial crisis, those numbers are significant. In fact, these sums are so large that, if the tax code is not changed, it may even discourage some individuals and families from considering debt resolution as an option and force them to consider bankruptcy with all of its long-term pain instead.
American families deserve better. In many cases, they are struggling at no fault of their own— they have been laid off, have a sick child, or have gone through a divorce or other family emergency. The typical debt resolution client owes more than $25,000 in unsecured debt and is already behind on at least one or, in many cases, even seven or more accounts. According to a recent report, consumers see their overall debt reduced by nearly 32% on settled accounts. Eliminating this debt frees families, and it helps the creditors that are owed.
Turning American families’ forgiven debt into taxable income is simply unfair. And Americans are worried about the fairness of the federal tax code. According to a recent Associated Press survey, 60% of Americans think the federal tax system is unfair. That number includes 65% of Republicans and half of Democrats.
Changing the tax code to eliminate the provision that treats forgiven debt as income is a simple way to make the federal system more fair.
The Joint Committee on Taxation must work quickly to complete its review of this issue, and when that report is done, lawmakers must change the IRS rules regarding discharged debt. Families who diligently work with creditors to eliminate credit card, medical, and other unsecured debt should not end up owing more to the IRS.
Denise Dunckel Morse is CEO of the American Association for Debt Resolution, a nonprofit advocacy group that educates consumers and policymakers about debt resolution and holds debt resolution companies to the highest standards.
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