When you are overwhelmed about debt, any chance at relief may seem like a good idea.  At a certain point, many creditors may decide that getting something is better than nothing, and offer to cancel a portion of your debt.  What are the downsides, if any, to Cancellation of Debt, aka Debt Forgiveness?

What is Debt Forgiveness?
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds as income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

If you owe a creditor $10,000 but haven’t been making payments, the creditor might offer to forgive the debt if you make a lump sum payment of $2,000.  This is a savings of $8,000, but this is also generally considered taxable income on your next tax return.  $8,000 in extra income may bump you up into a higher tax bracket, causing you to owe significantly more than you expected to the IRS come tax time.  Money owed to the IRS is usually considered a “priority” debt, which means that it will usually not be dischargeable in bankruptcy. So if you end up having to file for bankruptcy on your remaining debts, you are not only out the $2,000 that you paid the creditor to forgive $8,000 of debt, but you will not be able to discharge the taxes you will now likely owe to the IRS. (unless you meet the exceptions allowing you to discharge your tax debt).

While it is natural to want to pay off your debts without having to file for bankruptcy, it is important to look at the big picture.  Will you be able to pay the IRS the taxes you will likely owe if you are able to get one or more of your creditors to cancel or forgive a portion of your debt?  Will you be able to pay off any other creditors who may not agree to forgive any of what they are owed?  Can you afford to pay a lump sum to the creditors who may agree to debt forgiveness?  How will that impact your ability to pay your other debts, as well as the interest and penalties that would accumulate if you weren’t able to?

There are many important questions to consider when deciding the best course of action to obtain a fresh financial start.

Financial Freedom Law is an experienced, compassionate partner that can help you decide among many options, depending on income, assets, the nature of your debts, and the goals you may have after completion of a Chapter 7 or Chapter 13 bankruptcy.  Please contact our Sacramento office at 916-313-9069 or via email at info@california-bankruptcyattorney.com