Is Bankruptcy Better Than Debt Settlement?

06 Jun Is Bankruptcy Better Than Debt Settlement?

Bankruptcy may be a better solution, for a consumer with too much debt to pay, than a negotiated settlement with the creditors. Debt settlement companies will probably not tell you this, but you could end up owing tax if you settle with your creditors for a discount rather than discharging debts in bankruptcy.

The IRS assesses a tax on cancelled debt. If you pay less than the full amount of a debt, under most circumstances, the amount of unpaid debt that is cancelled is included in your income for tax purposes. The only general exceptions available to most taxpayers are bankruptcy or insolvency. If the cancelled debt is connected to a personal residence, it may be excluded from income by a special, limited exception enacted by congress in 2007, and extended through 2012 by the TARP legislation in late 2008.

Many factors must be considered before a decision to file bankruptcy is made. It is always best to consult with a lawyer about such a complex matter. While it is usually best from a tax standpoint to discharge debt in bankruptcy rather than by paying less than the full amount due through a negotiated settlement, other factors may weigh in favor of the negotiated settlement. This principle applies to home loans as well as unsecured debt.

Although the Mortgage Forgiveness Debt Relief Act of 2007 excludes qualified personal residence debt from the law classifying cancelled debt as income, the definition of qualified personal residence debt includes only purchase and renovation loans. If a portion of a refinance loan was used to pay off consumer debt, forgiveness of it still generates a tax liability outside of bankruptcy.

Be sure to investigate the tax liability that may be associated with a debt settlement arrangement, short sale or even foreclosure. The proper use of a bankruptcy proceeding could protect from the assessment of unexpected tax liability.

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I was admitted to practice in 1978. I am certified as a Consumer Bankruptcy Specialist by the American Board of Certification. I regularly speak on tax and bankruptcy issues at state, regional and national conferences. Years of experience in practice before the Internal Revenue Service and Oregon Department of Revenue have given me the background to resolve a large variety of consumer tax issues.
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