A Tax on Money You Don’t Owe And Never Had

Imagine this – you receive a letter in the mail from an organization called Strike Debt about some beneficent program called The Rolling Jubilee. You open it and learn that the group has paid off your debt for you – all of it. You check your accounts, and it’s true. These modern-day Robin Hoods expect nothing back. They only want you to look at their good deed as a gift and an opportunity to start fresh. It’s time to celebrate, right?

Don’t be so sure. Thanks to a little thing called cancellation of indebtedness income, the IRS is absolutely ready to wipe that smile off your face. How? By treating the canceled debt as taxable income. You see, the ability to add a totally illusory $20,000 to a person’s annual income is the kind of black magic they teach at the IRS version of Hogwart’s – and all IRS accountants are alumni. As a result, former debtors end up paying a tax on their sudden freedom, and they may also be disqualified from government programs or sliding-scale care providers. In other words: when debt goes down, quality of life might just follow.

Now, the IRS doesn’t always treat canceled debt as taxable income. In fact, there’s a list of exemptions on the website:

Canceled Debt that Qualifies for EXCEPTION to Inclusion in Gross Income:

  1. Amounts specifically excluded from income by law such as gifts or bequests
  2. Cancellation of certain qualified student loans
  3. Canceled debt, that if paid by a cash basis taxpayer, would be deductible
  4. A qualified purchase price reduction given by a seller
  5. Any Pay-for-Performance Success Payments that reduce the principal balance of your home mortgage under the Home Affordable Modification Program

Canceled Debt that Qualifies for EXCLUSION from Gross Income:

  1. Debt canceled in a Title 11 bankruptcy case
  2. Debt canceled during insolvency
  3. Cancellation of qualified farm indebtedness
  4. Cancellation of qualified real property business indebtedness
  5. Cancellation of qualified principal residence indebtedness

It’s easy to assume that Strike Debt’s actions fall under the first category. They pay off debt as a gift, so a lucky recipient who’s finally been freed from his MasterCard shackles shouldn’t owe anything to the IRS. Unfortunately, this assumption oversimplifies the situation and leaves out key factors that may deny debtors tax exemption.

Yves Smith explains more in a recent article. According to Yves, “There are at least two reasons why the transfer might be deemed to be income rather than a gift. The first is that Rolling Jubilee, by buying debt, is participating in a commercial activity. The second is that the IRS has very stringent notions of who proper recipients of gifts are. Middle class individuals are not seen by the IRS as proper recipients of charity.”

Is there a way around this? Possibly, but simply reading through the FAQ on the IRS site and Googling until you’re cross-eyed won’t work. Seeking a ruling won’t work either, because the IRS will not issue rulings on whether or not a transfer is considered a gift (that’s technically what’s happening when Strike Debt bails out debtors). We have come across one possible way to resolve the issue, though. It comes from Yves Smith, and here it is: “Rolling Jubilee should get one of its sympathetic celebrities to write a check to a serious tax lawyer to take a proper look.” Any takers?

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