Debt Relief Blog Series: Determining Your Best Option. Part I: Tax Consequences

Weighing your debt resolution options can be overwhelming.  We are posting a 5-part blog series over the next month to help breakdown some of the most common and important considerations. Here are the topics we will be covering:

• What are the tax consequences?
• How the debt is settled - lump sum payment vs. structured payment plan.
• Impact in your budget - is it viable or will repayment efforts create other new debt?
• How will the debt resolution Impact your credit score?
• Legal protection during the process and proper documentation.

We welcome your questions!  We offer a free consultation with a licensed attorney to discuss your debt resolution options and provide a qualified recommendation for the best course of action based on your unique circumstances.   Call us today at 866-261-8282or schedule an appointment online.  

What are the Tax Consequences of Debt Resolution?

• Debt Settlement: Debt settlement is when you negotiate a debt reduction with your creditor(s) for a lump sum payment to legally settle the debt.
  • Tax Consequence: In most cases, the portion of the debt that your creditor "forgives" is considered taxable income.  You will receive a tax form 1099-C, Cancelation of Debt from your creditor.  By law, any creditor that writes off $600.00 or more of debt is required to send you a 1099-C IRS form.
  • Example: You owe $10,000 to Creditor A.  They agree to settle the debt for a lump sum payment of $4,500.  You will have to pay taxes on the $5,500 that they didn't collect, as imputed income.

• Debt Management Programs: Debt management programs attempt to negotiate payment terms with creditors individually in order to structure a repayment plan with the goal of reducing and paying down debt.
  • Tax Consequence: Similar to debt settlement, if a creditor agrees to voluntarily forgive a portion of the debt, you will be responsible to pay taxes on the difference between what you owed and what you actually paid.

• Chapter 7 Bankruptcy: Filing Chapter 7eliminates:
  • General unsecured debt, such as credit cards, medical bills, old utilities, etc;
  • Personal loans;
  • Loan deficiency debt (i.e. foreclosure, vehicle repossession, etc.);
  • Surrendered personal property (i.e. voluntary repossession for a home or vehicle).
  • Tax Consequence: Bankruptcy is a non-taxable event.  You will not be responsible to pay taxes on any of the eliminated debts.

• Chapter 13 Bankruptcy: Chapter 13 is a debt management program that allows you to restructure both unsecured and secured debt obligations, allowing you to reduce debt and ultimately eliminate any remaining balances at the completion of the 36 - 60 month program.  Similar to a Chapter 7 bankruptcy, you can also surrender unwanted personal property under Chapter 13 bankruptcy.  A deficiency claim from surrendered property  is converted to an unsecured debt and paid back at 0% interest and typically at a reduced rate.  The creditor only has a limited timeframe to register a claim (called a "Proof of Claim") and failure to timely file a claim means complete debt elimination at the end of the repayment plan.
  • Tax Consequence: Filing Chapter 13 bankruptcy is a non-taxable event and therefore any debt that is eliminated will not create a tax obligation.

• Other (Short Sale, Deed in Lieu of Foreclosure, etc):Similar to debt settlement, these debt elimination strategies rely on a creditor agreeing to take a reduced amount on a debt obligation.
  • Tax Consequence: Similar to debt settlement, your creditor is required to send you a 1099-C for the cancellation of debt.

Call Today for a Free Consultation!

If you have already experienced a debt resolution that would create taxable event, we recommend you talk to a tax professional to plan for the debt.  If you are at the point of weighing your options, we recommend you take advantage of the free consultation to ensure you proceed with the program that is going to be best for your circumstances.  Once a tax debt is established, it is non-dischargeable in bankruptcy for several years.  In the meantime, the IRS could levy personal property if you don't have the ability to pay. Call us today at 866-261-8282 to schedule a time for a free consultation with a licensed Michigan attorney.  We offer phone consultations or in-office at any of our six Michigan locations:  Detroit, Ann Arbor, Flint, Dearborn, Southfield or Warren.