Debt Settlement? Look out for Tax Liability!

debt settlement look out for tax liability

I have been receiving calls from people who are looking into settling debts with creditors for less than the complete amount owed. This is sometimes possible, and sometimes a good idea. However, people are surprised to find out that they may be creating income tax liability by doing this.

Yes, it’s true: debt forgiveness is considered income by the Internal Revenue Service! But it doesn’t count if you file a bankruptcy petition during that Tax Year.

This is especially important for people who have recently done a short sale of a home and in the process, paid off part of a second mortgage or a Home Equity Line of Credit.

Or, you may be a homeowner with a junior lien that is no longer fully secured by the value of the property, and the lender might be contacting you asking that you pay a portion of the amount owed to get rid of the lien. If you take that deal, the IRS will be looking for income tax on the forgiven portion of the debt.

So, if you are eligible for some kind of bankruptcy relief, it may be a much better deal for you to go the bankruptcy route, whether it is a Chapter 7 Fresh Start, or a Chapter 13 Plan where you pay all or part of the debts.

Most of my Chapter 13 clients repay a Very Small part of the unsecured debt – it’s worth looking into, to find out how much of your unsecured debt might be eligible for the Chapter 13 discharge.

See my articles “Should I File a Chapter 13 Bankruptcy?” and “Top 5 Reasons to File a Chapter 13 Bankruptcy.”

 

IRS Circular 230 disclosure: Any tax advice contained in this memorandum (including any
attachments or enclosures) was not intended or written to be used, and cannot be used, for the
purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting,
marketing, or recommending to another party any transaction or matter addressed in this
memorandum. (The foregoing disclaimer has been affixed pursuant to U.S. Treasury
regulations governing tax practitioners.)

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