Unlike Bankruptcy, Private Debt Settlement Can Lead to Big Tax Problems

1099 Tax Liability from Debt SettlementIt’s another symptom of this prolonged recession. Private debt settlement companies are cropping up like mushrooms all over the Bay Area. Their advertisements urge people not to consider filing bankruptcy and promise that they can negotiate settlements with your creditors instead. In general these debt settlement outfits are not attorneys, and they cannot offer any legal advice. Sadly, they often cause their customers real economic hardship by diverting them from the more powerful debt relief afforded in bankruptcy. I’ve written before in this blog about the fact that credit card companies often sue the customers of these debt settlement companies, contrasting this to bankruptcy, where creditors are prevented from all collection efforts while the bankruptcy automatic stay is is effect. In this post, however, I want to focus on another consequence of private debt settlement—taxes.

Consider one of the most commonly advertised services of these debt settlement outfits. They promise to get rid of a home equity line of credit or second mortgage for pennies on the dollar. In the Bay Area, because nearly twenty-five percent of homes are under water, there is a huge market for these debt settlement companies who sell their customers on the dream that the lender of their $150,000 equity line might settle that debt for just $20,000 and remove its lien on the home. Assuming that these debt settlement companies can actually achieve such a settlement, that sounds very appealing, right? The homeowner avoids fling bankruptcy and gets rid of an enormous debt. So, what’s the problem? The problem is these Bay Area homeowners are now about to suffer a huge tax problem.

Unlike with a debt that is discharged in bankruptcy, debt such as the $150K home equity line of credit in the above example that is cancelled through private settlement is taxable as though it were income to the homeowner. Yes, you heard that right. The lender who agreed to receiving just $20,000 on the $150,000 equity line will send the homeowner and the IRS a 1099c for that tax year. And the result is that because the home equity line of credit was a recourse loan under California law, the homeowner will owe the IRS income taxes on the 130,000 of cancelled debt just as if she had received that same amount as income. Unless the homeowner can prove to the IRS that she was insolvent when the debt was settled (a task that may be impossible if she has 401(k) or IRA savings) she will owe income taxes on the amount of the forgiven debt. Of course, when the debt settlement sales guys are squawking about how you should avoid filing bankruptcy, they never tell you that their debt settlement program may cause you to owe an enormous tax liability to the IRS. And it’s not just home equity lines that lead to this result, settlement of credit card debts outside of bankruptcy leads to the same tax 1099 liability on the cancelled credit card debt.

However, had our Bay Area homeowner consulted with an experienced bankruptcy attorney first, she would have learned that if her equity line of credit and her credit card debt were discharged in bankruptcy, she would face no tax liability for such discharged debts. If she had consulted with one of our San Jose bankruptcy lawyers, she would have learned as well that in many cases, if her home is now worth less than the balance owed on her first mortgage, she may well have been able to strip off her home equity line of credit in Chapter 13 bankruptcy and emerge from bankruptcy owning the home free and clear of that second loan. And without owing taxes on her discharged debt.  If she had only sought out solid legal advice from a competent bankruptcy attorney, instead of being persuaded by the slick sales pitch of a debt settlement company, she would have learned that she may have forever discharged some or all of her debts without any tax consequence at all. And if she had only sought a free consultation with one of our bankruptcy lawyers she would learned that bankruptcy would have protected her from law suits, wage garnishments, harassing phone calls and all manner of other collections by the automatic stay in bankruptcy.

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