A Trap for the Unwary: Debt Forgiveness is Income

If you owe money and your debt is “forgiven” (i.e. written off or reduced) by your creditor, this reduction in debt is considered taxable income to you.  Really?  Yes – in most cases this is true and is something that most people don’t know.  The following is a typical conversation I have with prospective clients who are considering bankruptcy.

 Prospective client:       If I file a chapter 7 bankruptcy won’t the $50,000 in credit card debt I owe  be wiped out (legal term is discharged)?  

Me:  Yes – in most cases it would be “wiped out” unless there is some type of fraud on your part or the debt was incurred just before you filed for Chapter 7 bankruptcy. 

Prospective Client:      If I tell my credit card company that I may file for bankruptcy won’t they be more willing to make a deal with me and settle for a small amount of the original debt?

Me:      Many times a creditor will be willing to take much less than what is owed if they think you will be filing bankruptcy.

Prospective Client:      That would be great – then I can get out from under this debt and not have to file for bankruptcy (which is something no one wants to do). 

Me:      It is great – but you need to realize that the creditor is required to issue you a 1099 for the amount of debt that was reduced (i.e. forgiven) and the amount reported to the IRS on the 1099 will be taxable income to you.

Prospective Client:  What?

Me:        Under the tax code, the amount of the debt that is forgiven is considered income to the debtor.  For example, if you have $50,000 in credit card debt and you are able to settle the account by paying $10,000, you will be issued a 1099 by the creditor for $40,000 and you will have to pay income tax on this $40,000. 

At this point the potential client is usually somewhat confused and not at all happy.  While it is much better to pay tax on $40,000  (approximately $8,000 to $12,000 depending on your tax rate) then to pay $40,000, people who are calling me to discuss bankruptcy are usually in very difficult financial situations and paying either creates a big problem.  It is also important to note that under the bankruptcy code it is usually very difficult to get tax debt discharge.  Thus, while you may be able to have the $50,000 in credit card debt discharged, if you reach a settlement and then end up with a $12,000 tax debt you cannot pay, it may be very difficult to get this tax debt discharged in bankruptcy.

The forgiveness of debt income problem in many cases is the deciding factor to filing a bankruptcy.  Under the law, debt that is discharged (i.e. forgiven) in a bankruptcy case does not result in forgiveness of debt income.  The other major exception to the forgiveness of debt income rule is the Mortgage Forgiveness Debt Relief Act of 2007.   This law was passed by Congress to help address the current mortgage crisis in the housing industry and allows up to $2,000,000 in debt to be forgiven during the years 2007 to 2012 without resulting in income IF the debt was secured by your principal mortgage.

If you are trying to negotiate yourself out of debt, you need to be aware that any debt forgiven by your creditor in most instances will be considered taxable “income.”   Being aware of this will allow you to consider all your options and make the best choice.  The rules are complex and you should always consult with an attorney who is familiar with bankruptcy to help determine your best option.

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