Canceled credit card debts come back to haunt taxpayers

— -- Billions of dollars in credit card debt that was charged off during the Great Recession— some of it decades old — is coming back to haunt borrowers in the form of unexpected tax bills.

Debt that is canceled or forgiven is considered taxable income, something many borrowers don't realize until they receive a 1099-C tax form from their lender. The IRS projects that creditors will send taxpayers 6.4 million 1099-Cs in 2012, up from 3.9 million in 2010.

The increase likely reflects the rise in credit card defaults during the economic downturn, says Gerri Detweiler, personal finance expert for Credit.com. Moody's Investor Service estimates that the nation's six largest credit card companies wrote off more than $75 billion in uncollectible balances in 2009 and 2010.

Taxpayers who receive a 1099-C, which is also submitted to the IRS, are liable for the tax bill unless they can prove that the debt was discharged in bankruptcy or that they were insolvent when the debt was canceled, says Jennifer MacMillan, an enrolled agent in Santa Barbara, Calif.

Shelley Cartier, 48, of Austin, recently received a 1099-C for a credit card debt that was more than 20 years old. Cartier says she filed for bankruptcy in the early 1990s but no longer has the paperwork to prove the debt was discharged. Numerous calls to the financial institution have gotten her nowhere, she says.

"I can't file my taxes until I get it cleared up," Cartier says.

Making matters worse, a significant number of 1099-Cs contain errors, says IRS Taxpayer Advocate Nina Olson. Treasury regulations encourage financial institutions to issue 1099-Cs for debts if they haven't tried to collect them in at least 36 months, even if the debts haven't been forgiven, she says. In other cases, taxpayers have received duplicate 1099-Cs for the same debt, she says.

The number of 1099-Cs could rise even more if a tax exemption for canceled mortgage debt expires at the end of this year. Legislation enacted in 2007 excludes mortgage debt on a principal residence that was forgiven as a result of a loan modification, short sale or foreclosure. If the exemption isn't extended, thousands of homeowners who owe more than their homes are worth could be on the hook for taxes, according to the National Association of Realtors.

When the law was enacted, Olson says, "no one conceived it would take longer than 2012 to dig out of the mortgage crisis."