Debt Forgiveness: Part 1

It’s tax time again, and this year your accountant may be asking you about debt forgiveness.  In addition to the usual questions about your income and deductions, you may be asked if any of your debt was forgiven in 2011.

There are a couple of ways in which your debt can be forgiven.  One is through the filing of a bankruptcy.  If you found yourself in financial trouble in 2011 and were forced to file bankruptcy to get out from under medical debt or credit card debt, these debts were discharged, or forgiven.  You no longer owe money to these creditors, and they can’t come after you in the future or sue you for the debt. 

In the case of a bankruptcy, there are no tax consequences involved.  You do not have to pay income tax on any of the debt that is discharged, no matter what type.  If any of your creditors 1099 you, there is a form you can file with your taxes to let the IRS know that the debt was discharged through a bankruptcy and you won’t be paying taxes on it.

Even if you don’t file bankruptcy, another way a debt can be forgiven is through a settlement with a creditor.  A lot of creditors are working with their customers and accepting less than what is owed.  For example, you may owe a credit card debt in the amount of $18,000, and the creditor may accept a lump sum payment of $10,000 as payment in full on the account. 

In this case, however, the IRS looks at the transaction and says that you were forgiven $8,000 of your debt to that creditor and therefore have to claim that amount on your taxes.  What you will end up paying for this forgiven debt is a question for your accountant, but just be aware that there will more than likely be a tax obligation.

When negotiating with your creditors, it’s important to look at the big picture.  If you owe more than one creditor, but only one will settle, you may need to determine if it’s worth it.  You may settle on one account, but if the others won’t budge, you may find yourself needing to file bankruptcy anyway.  The settlement won’t cause you tax problems in this case, but the money you spent could have gone toward living expenses or necessary attorney fees. 

Submitted by:

Kerry Hammond, Esq.