How Debt Forgiveness Can Become Taxable Income

February 16, 2012

While often difficult to reach, settlements between debtors and creditors involving debt forgiveness are usually not as attractive as they seem, and can often lead to additional, unforeseen burdens on consumers. This irony may become all too clear to the consumer trying to settle his or her high credit card debt.

Credit cards are a popular vehicle for consumers to obtain and use debt. Astonishingly, the total consumer debt in the United States stands at nearly $2.5 trillion, according to the Federal Reserve.

Of that amount, credit card debt is categorized as "revolving debt." The Federal Reserve reports that in November 2011 total revolving debt was around $808 billion.

Some have suggested the next financial crisis could develop out of consumers being overextended with credit card debt, as they attempt to maintain their status quo in spite of creditor harassment, job loss, stagnant wages, falling home values and the continuing recession.

Average Balance Is $15,000

The high current numbers show the toll the recession has taken over the last few years. Since 2008, almost $200 billion in revolving debt has been wiped out. Nonetheless, the Federal Reserve reports that the U.S. has more than 600 credit card issuers and for households with credit card balances, the average balance is staggeringly over $15,000.

Credit cards represent the largest portion of revolving debt, and millions of transactions occur daily because of the ease and convenience of credit card use.

Unfortunately, that ease of use is one element that implicates them in financial woes. When problems occur, credit cards may be the last source of credit for many consumers; the cards may be used as "life preservers" when everything else runs dry.

Of course, they can turn rapidly into concrete life preservers, dragging you and your finances ever downward.

How to Reduce Your Credit Card Debt

When you have run up high credit card debt because of a job loss or medical issues, all may not be lost. If you begin earning sufficient income again, you may want to work out a deal with your credit card company.

You may be able to pay off the full balance. For most people with financial troubles, this generally is not an option. Another option is to negotiate with the credit card company that you will pay a portion of the debt, and the company will forgive the rest.

This may be possible, but credit card companies do not make millions of dollars in profit by forgiving debts very often. To be successful, you have to have pay down enough debt to make the overall transaction attractive to the lender. If you have $20,000 of credit card debt and you offer to pay $1,000, it is unlikely the company will accept the offer.

If you offer to pay $15,000 in return for the lender forgiving the remaining $5,000, there may be more interest. While you may feel like celebrating, the forgiveness, however, is not free. It may come with a string attached.

Death and Taxes

Yes, the Internal Revenue Service will want its share. Under the Internal Revenue Code, gross income "means all income from whatever source derived." If you owe $20,000 in credit card debt and have $5,000 forgiven, the IRS sees that $5,000 as income.

This is because economically, it is the same as if you had earned an extra $5,000 and paid the entire debt off. You would have been taxed on that $5,000 if it had arrived in your paycheck, and the IRS treats it no differently when it comes in the form of debt forgiveness.

This means you owe taxes on that amount of income, so for the average taxpayer, it could amount to an additional $1,500 in tax obligation at the end of the year. In addition, while you received a $5,000 benefit with the forgiveness, it was not cash, so you have to find $1,500 from some other source to pay the tax bill.

Exemptions?

There are ways to avoid this situation. The IRS offers three "exemptions" to the matter of debt forgiveness. If you obtain the forgiveness in a bankruptcy, because of insolvency or in connection with your residence, your forgiveness may not be considered income and you would owe no tax.

If your finances have deteriorated to this level, you may wish to speak with a bankruptcy attorney. He or she can explain how bankruptcy can prevent credit card debt forgiveness from exposing you to additional tax liability and if any other exemption may apply to your situation. The lawyer can explain all of your potential options for dealing with large amounts of debt.

Article provided by Chicago Debt Solutions
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