Avoid the Debt Forgiveness Tax Trap

There is no question that bankruptcy should always be a last resort; you should try everything you can (outside raiding an IRA or pension) before filing. Many people do a debt consolidation through a home equity loan; others are able to make deals with their creditors for either a payment plan or a discounted lump sum payment. It is this last option that I want to talk about, as it does have its pitfalls.

The Rule

Many times, credit card companies will agree to compromise the balance, if it is paid off in one lump sum. The problem comes in when they knock more than $600 off the bill. In those cases, the banks are required to file a Form 1099C with the IRS declaring that discount as income. That's right, you may well have to pay taxes on the money you don't have to pay the bank! The IRS has a very informative publication on this.

The Exception

Like any rule, however, there are exceptions. In this case, there are three:

1. You are insolvent as the time the debt is written off. This is defined by the IRS.
2. You file bankruptcy before the debt is written off and the 1099C is issued.
3. You are a homeowner of residential real estate, where there was a sale or foreclosure that did not result in payment in full of the mortgage liens, and the debt was written off during 2007 to 2012. This one comes to you courtesy of the Mortgage Forgiveness Act of 2007. The IRS's website has examples to help you determine if you can qualify for this exception.

In essence, if you file bankruptcy prior to the issuance of the 1099C, or the forgiveness arose out of the sale of your residence between 2007 and 2012, there is no tax liability.

What to Do

I advise my clients that if they are looking to make deals with all their creditors for a certain percentage of the overall debt, they should do so with the advice of an accountant to determine the tax implications of the deal. If the total amount of money necessary to pay off the debt plus the taxes still makes financial sense to you, then go ahead. At least the 1099C will not come as a surprise, and you will have the money ready to pay the IRS when you file your return. If it is not, then bankruptcy may well be a better option. Feel free to contact my office for a free consultation to discuss those option.

Looking for more information about bankruptcy? Get the answers to the most frequently asked questions by downloading my free book, Top Questions People Ask About Filing Bankruptcy in New Jersey. It will give you the answers you need all in one place. Then call me at 888-857-8418 or contact me through this site for an appointment for a free consultation to discuss your case.