Creditors are willing to cancel all or a portion of your debt in certain cases, usually for delinquent accounts or in a mortgage short-sale situation. While this cancellation may have tax consequences, it is a good deal for the consumer. When dealing with creditors, be careful in negotiations and record keeping. If your debt problems are significant, you may need to consider either Chapter 7 or Chapter 13 bankruptcy as a final resolution and cancellation of your debt.
You can negotiate with the creditor for a reduced payoff of a delinquent bill, because the creditor may view this as its only chance to collect on the account. Offer a cash payment starting with 20 percent of the balance, and negotiate from there. Make sure that you negotiate cancellation of the remaining amount, and make it clear that your payment is settlement in full of the outstanding balance.
Get any agreement from the creditor in writing, before you make the payment. Have the creditor fax or mail you the agreement, saying what it will accept for payment and that it specifies this as payment in full. Only then should you send a payment by money order or certified check. Do not send a personal check or give electronic access to your bank accounts, as the creditor could withdraw more money than your agreement dictates, often at some point in the future.
Keep a copy of the canceled check, money order or receipt for cash payment, along with a copy of the agreement from the creditor. This is a legal record of payment that you should keep forever. If the account is sold or transferred to another collection agency, that agency could try to collect the outstanding balance. The record will prove you paid the bill in full.
The Internal Revenue Service usually considers canceled debt to be income. The creditor will send you a Form 1099-C, reporting the amount of the canceled debt as income. Include this in your taxable income, and pay the appropriate taxes with your yearly tax return. This is still an advantage over paying the entire bill. For example, if you are in the 15 percent tax bracket, and a creditor canceled $3,000 in debt, your tax liability is $450, meaning you still saved $2,550 over the original amount.
If you file Chapter 7 bankruptcy, the total liquidation of your nonexempt assets to pay creditors, all of your eligible debt is canceled by the bankruptcy discharge. Creditors are forbidden from collecting the canceled amount, and you are not liable for any income taxes on this canceled debt.
You work out your debts through court-supervised monthly payments to your creditors in a Chapter 13 bankruptcy, usually over three to five years. At the end of the court-ordered repayment period, any remaining eligible debt is canceled by the discharge order. The terms of this cancellation are the same as with a Chapter 7 bankruptcy.
In many cases cancellation of debt on your personal residence is tax-exempt. If the bank agrees to accept less than what you owe on your primary residence in a short-sale situation, the forgiven debt is not taxable. This applies to debt used to purchase or improve the residence and does not apply to mortgage debt used for other purposes, such as if you refinanced to pay for education or a vacation.
If a creditor cancels your debt, you may be able to exempt the canceled amount from your income if you are insolvent. Insolvency means that your total liabilities exceed the fair market value of your assets. Use IRS Form 982 to exempt debt cancellation income if you are insolvent.
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