May 04, 2020

In soliciting you for their services, debt relief agencies hide the most important consequence of obtaining forgiveness of your credit card debt.  When a loan is forgiven, the IRS defines that forgiven amount as gross income and subject to taxation.  For instance, if you owe a credit card company Sixty Thousand Dollars ($60,000) and a debt relief agency negotiates a settlement requiring you to only repay the credit card company Ten Thousand Dollars ($10,000), the IRS will determine that you earned Fifty Thousand Dollars ($50,000) as a result of the settlement and, at year’s end, you will now owe the Internal Revenue Service income tax for that amount.

In listening to radio ads or searching the internet, this fact will not be apparent.  For example, National Debt Relief, a leading debt relief agency, provides this information on its website:

“How can I get rid of credit card debt without paying?

If you find yourself unable to pay your credit card debts due to matters such as a loss of income or unemployment, you have options. You may even qualify for debt settlement. In debt settlement, you work with your creditors to settle your debt for less, and your monthly payments are often much lower than they would be if you continued to just pay your minimums. Another option could be bankruptcy. However, bankruptcy can have serious financial repercussions that could last for many years to come. If you’re interested in getting out of debt, you should consult with a financial advisor to determine the best option for you.”

National Debt Relief suspiciously omits the fact that by canceling credit card debt you create tax debt.  The IRS requires financial institutions to report any canceled debts (the portion forgiven during settlement) over Six Hundred Dollars ($600), and the debtor must report that amount as income on his tax return. Unlike credit card debt, tax debt cannot be discharged in bankruptcy. 

This reported income is automatically nontaxable whenever the debt is discharged in bankruptcy.  Outside of bankruptcy, you must persuade the IRS that you were insolvent at the time the debt was forgiven to avoid paying income tax for that amount.  For many California homeowners, this could prove difficult due to the accumulation of equity in their houses. Also, if the debt settlement renders you solvent, then you must pay taxes on the amount of your solvency. For example, imagine you own One Hundred Thousand Dollars ($100,000) in assets and have Two Hundred Thousand Dollars ($200,000) in credit card debt.  You now are insolvent since your liabilities exceed your assets by One Hundred Thousand Dollars ($100,000).  But if your credit card company settles for Fifty Thousand Dollars ($50,000), then you will become solvent since your remaining assets of Fifty Thousand Dollars ($50,000) will exceed your liabilities which are now nonexistent.  At year’s end, you will be liable to the IRS for income tax on the Fifty Thousand Dollars ($50,000) of your assets that exceed your liabilities.

Let’s be clear, the decision whether to file bankruptcy or seek an informal resolution of your debt is often complicated and requires careful consideration of a bankruptcy professional.  You should always contact a knowledgeable and honest bankruptcy expert to assess your options before engaging a debt relief agency.  A minefield of hidden liabilities underlies any attempt to relieve you from the burden of your debt and must be carefully navigated.