Debt Forgiveness: Part 2

In an earlier blog I discussed debt forgiveness on unsecured debts such as credit cards. I talked about the difference between discharging these debts in a bankruptcy versus settling these debts with your creditor for less than is owed. Discharging the debts through a bankruptcy does not leave you open to tax liabilities in the next tax year, but settling the debt with the creditor may.

Overwhelming credit card debt is one of the top reasons people file bankruptcy. One late payment can raise your interest rate, making it impossible to pay down the balance. If you only make the minimum payments, it can take decades before the debt is paid off (assuming you stop using the card).

In addition to unsecured debt, many people find themselves in need of debt forgiveness when it comes to mortgages. Some people want to keep their home, and they enter into a chapter 13 bankruptcy in order to put the arrears in a bankruptcy plan so that they can catch up over a period of time. But others are looking to walk away from the home and be free of a mortgage payment they can no longer afford.

When this is the case, and if you qualify, it is possible file a chapter 7 bankruptcy. This not only discharges the credit card and medical debt, but allows you to surrender your home to the bank that holds the mortgage. The bank will then sell the home at foreclosure sale, and any deficiency between what they sell it for and what you owed them is discharged in the bankruptcy as well. There is no tax liability to the debtor who files a chapter 7 bankruptcy and surrenders a home, whether there is a deficiency with the bank or not.

Some banks will consider a short sale, which means they will accept less than what is owed if you find a buyer willing to pay. In this case, you are technically being forgiven of some of the debt you owe the bank. If you owe $200,000 and find a buyer who pays the bank $175,000, you have been forgiven the $25,000 difference. This would normally be taxable, but thanks to the Mortgage Debt Relief Act of 2007, many people will not have a tax liability.

The Mortgage Debt Relief Act of 2007 allows a taxpayer to exclude this forgiven amount and not pay taxes on it. There are a few requirements and limitations, however. For example, the home must have been your principal residence (not a rental property or second home). There is also a $2 million cap on the forgiven debt if you qualify under this act.

As always, when you are dealing with tax questions, you should always consult a knowledgeable accountant. These are just a few things to think about when you are considering taking steps to settle or discharge your debt. If you think that you need to look into your bankruptcy options, Greenwald & Hammond offers a free initial consultation where you can discuss your concerns with an attorney.

Submitted by:

Kerry Hammond, Esq.