Our Tax and Crime blog series this time will discuss the tax treatment of canceled debts. I will use a recent California appellate case (Tak Chun Gaming Promotion v. Long) to illustrate the potential tax consequences when gambling debts or any debts are canceled or deemed to be canceled income. Learn more about the taxation of gambling and debt cancellation.

The Tak Chun case immediately became a classic, sounding like a plot from “The Hangover” movie series. According to the court’s opinion, a man named Kevin Long from Arcadia borrowed about $11 million to gamble at a Macau casino. The court wrote that he only repaid about $1.7 million of the loan. Tak Chun Gaming sued Long in a California court to recover the debt. The California court dismissed the case because of a longstanding common law rule that California courts generally do not enforce gambling debts.* So, in short, Kevin Long gambled away over $9 million of house money and got away with it… or did he?

While we’d love to buy Mr. Long a beer for his legendary courtroom victory, his triumph may come with potential tax consequences. Generally, when a person’s debt is canceled, they recognize income. To illustrate this principle, let’s say I purchase $100 of groceries on a credit card. I borrowed $100 from the bank to buy groceries, thus owing a $100 debt. My bank transfers $100 to the grocery store (minus some fees). I don’t recognize $100 of income because, although I bought $100 of groceries, I have an obligation to pay the bank $100.

Now, let’s say for some reason the credit card company forgives or cancels my debt. I borrowed $100 and received $100 worth of groceries, but no longer have to repay this $100. I may now need to pay taxes on the $100 worth of groceries I received.

Similarly, Mr. Long also received $11 million in gambling tokens. He didn’t receive taxable income when he received the tokens because he had an obligation to repay the $11 million debt. Since the debt has been canceled, he may have to pay income tax on at least some portion of the canceled debt.

There are some exceptions to the debt cancellation rules. Debts discharged in bankruptcy, debts canceled by insolvent taxpayers, and certain canceled home mortgage debts may not require taxation. Perhaps Mr. Long could leverage some of these exceptions.

At RJS LAW, we assist clients with various tax audit and related issues. Additionally, we provide advice on gambling taxes, estate planning, will certification, and domestic and international tax planning for clients. If you have tax issues or want to discuss tax and estate planning to avoid tax problems, please call 619-595-1655 for a free consultation.

• Before you run off to Vegas and max out your credit cards, see if you can replicate Mr. Long’s feat, you should be aware that there are exceptions to the general rule that California does not enforce gambling debts. Casinos and other lending institutions are aware of these exceptions and may protect themselves better than Tak Chun Gaming. Your performance may not be as good if you attempt to replicate Mr. Long’s feat. So please borrow and play responsibly!