Taxes, Debt Forgiveness and Bankruptcy

Debt Forgiveness and Bankruptcy

Debts forgiven in bankruptcy are never taxable. However, some debts forgiven outside of bankruptcy may create a tax liability for the debtor. Let’s take a look at few tax issues debtors may face after settling debts outside of bankruptcy:

Debt Settlement On Credit Cards

As we have mentioned previously, many debtors are so anxious to avoid bankruptcy that they are willing to pay to have debts settled for “pennies on the dollar.”  The biggest problem with credit card debt settlement, outside of the fact that it rarely works out as advertised, is that the forgiven debt is treated as income by the IRS.  This means that if the debtor does manage to have $10,000 of credit card debt forgiven without the help of bankruptcy, the IRS will require the debtor to pay taxes on it.  If the debtor doesn’t have the cash, this could create an even larger problem.

Short Sales

In an attempt to avoid foreclosure and bankruptcy, some homeowners seek out short sells and the forgiveness of their mortgage balance.  This may seem like a sweet deal for debtors wanting to avoid bankruptcy; but the deal can sour if the mortgage balance is not forgiven in a timely manner. Right now, the IRS is waiving tax liability for mortgage debt forgiven if the short sale was for at least $50,000 less than the balance of the mortgage. However, this waiver expires December 31, 2012.  That means that the short sale and debt forgiveness must happen before that date and if it doesn’t, the debtor will owe taxes on the mortgage balance.

Before a debtor decides to seek debt forgiveness outside of bankruptcy, they need to closely examine how such a move will impact their tax liability.