Every night there's another commercial on television about reducing your credit card debt without filing bankruptcy. It sounds like a wonderful opportunity. The companies that offer this service tell you that with their help you could be paying pennies on the dollar to pay off your credit card. But debt reduction has substantial drawbacks you might not know about.
Debt reduction is different from debt consolidation or credit counseling to reduce interest rates. Debt reduction actually allows you to pay a portion of the bill in a lump sum and have the creditor wipe the bill from the books. Credit counselors often negotiate lower interest rates to help you pay the debt sooner. Debt consolidation simply allows you to put all your debt under one roof at a lower rate.
How It's Done
If you work with a debt reduction company, you agree to pay the company a specific amount every month. The company takes a fee from each amount you pay. Once you accumulate a specified amount, the company negotiates with the creditor to accept this amount as payment in full. If accepted, you then begin to accumulate money to pay the next bill in full. Often, you can negotiate these types of arrangements on your own and save the cost of the fee paid to the debt reduction company.
If you check the U.S. tax code for a definition of gross income, you'll find section 61(a) (12) lists income from discharge of indebtedness as income. That means if you cancel principal from a debt owed, you pay taxes on that money as though you earned the funds. If you wipe out $30,000 of debt principal, you owe taxes on $30,000. At tax time, you'll receive a form 1099-C or 1099-A showing the taxable amount to include with your income.
Lowered Interest and Bankruptcy
There are exemptions. Debt reduction from bankruptcy or debtor insolvency doesn't count as taxable. The provision also doesn't count lowering interest rate as taxable since you aren't reducing the principal but simply lowering the burden of interest. Loan forbearance programs also don't count.
In the case of debtor insolvency, the debtor has more debt than assets on the day of debt cancellation. If you can negotiate a settlement for creditors to accept less, but have no assets left, the IRS understands you are bankrupt without the court proceedings and you don't have to pay tax on the amounts you wiped out. For example, suppose you had $4,000 worth of assets and $20,000 worth of debt but a parent gave you $10,000 that the creditors agreed to accept. Since you personally were $16,000 insolvent, the $10,000 of benefit you received is not taxable. If you had $16,000 of assets in the same situation, you'd only be $4,000 insolvent so $6,000 would be taxable.
Mortgage Forgiveness Debt Reduction
Defaulting on a mortgage that's higher than the value of the home does not necessarily trigger a taxable incident. The Mortgage Forgiveness Debt Relief Act of 2007 and later legislation gives an exclusion of the debt reduction from income to debtors who used the funds to purchase, build, renovate or refinance a primary residence, up to $2 million. You don't receive the exclusion on debt you wipe out on a home equity loan used to purchase vehicles or consolidate other debt, just on the debt to purchase a home, build or renovate. If you lose your home and the mortgage or equity loan is higher than the value of the home, but most of the loan was due to debt consolidation or expenses for other items, you have a taxable incident on that amount.