This is something that comes up during the short sale of a home or the compromise of a debt with a creditor. Basically, whenever a creditor is paid less than what is owed, and does not pursue the debtor for the balance, that balance is considered "forgiven."
Okay, but so what? So the creditor agreed to take less, and I am off the hook for the balance. Isn't that a good thing? Well yes, in a lot of ways, but you should be aware of a "gotcha" in that deal that most Americans don't know about: you have to pay taxes on the forgiven debt!
Yes, that's right. The IRS considers forgiven debt to be income and taxes it. For that reason, the creditor will send a 1099 to the IRS for the forgiven amount, and the feds will expect to see that income as a line item on your tax return.
Are There Ways to Deal With It?
There are two ways to deal with this. The first is to negotiate deals with creditors with the assistance of a tax professional. So, for example, if you are offering 60% to creditors, and they all agree to take it, talk to an accountant or tax attorney about the estimated tax liability if the deal goes through.
If you have the funds to pay the creditors and the taxes, then it is still a good deal. Just set the tax money aside in a separate bank account, ready to pay out when you eventually file your tax return.
The second way is to avoid the tax entirely by claiming to be insolvent. This makes the debt forgiveness non-taxable. If your accountant thinks this will fly, then file a Form 982 with your tax return. Hopefully, that will convince the IRS to waive the tax. The other way is to go bankrupt, which is, in itself, a statement of insolvency.
So What Do I Do?
If you have a significant amount of debt that you want to resolve, and you want to avoid tax consequences, then bankruptcy might be a better alternative.
For help deciding whether bankruptcy is a possible solution, download my free book, Am I In Too Deep? A Guide to Knowing When You Need to File Bankruptcy in NJ.
If you live in southern New Jersey and are considering filing bankruptcy, please feel free to call me at 856-432-4113 or contact me through this site for a free consultation in my Woodbury office to discuss your case.
If you are looking for more information about bankruptcy, then download my free book,Top Questions People Ask About Filing Bankruptcy in New Jersey.