Debt and Taxes

by labrelawoffice

Taxes (Photo credit: Tax Credits)

“Mr. LaBre, I’ve got myself into a world of financial trouble.”

“What kind of trouble?”

“Well, I’ve got credit card debt of $50,000. I’ve got a mortgage on my home for $200,000, but the house is only worth $150,000. I’ve got a cabin on aprivate lake up North; that’s got a $100,000 mortgage, but now, after the crash, it’sonly worth $60,000.”

“How much are you earning?”

“About $65,000 a year.”

“How much of your income is going to pay off those debts?”

“By the time I’ve paid on the two mortgages and the credit cards, and paidthe utilities, we hardly have enough money to eat and feed our four kids.”

“How did you get into this mess?”

“Well, like a lot of folks ten years ago, I thought that prices on real estatewould always keep going up. So my wife and I thought that the houses wouldmake good investments. We didn’t worry about the credit cards; we thought we’d sell the lake property for a profit and just pay them off. Then came the crash. After that, the values went down, and, to live, we used the credit cards rather than cash.”

“Have you thought of bankruptcy?”

“Yes.  My wife and I have thought about it. But what we’d really like to do is to see if you can get the banks holding the mortgages and the credit card companies to write down the amount of the debt we owe.”

“You could do that in a Chapter 13 Bankruptcy, or you would probably qualify for a Chapter 7 Bankruptcy and eliminate all of your debts”.

“We really don’t want to file bankruptcy. We want you to get our creditorsto write down and forgive a part of the debt. We want the mortgages to be written down to the current value of the properties, and we want the credit card companies to forgive all of the interest we’ve had to pay.”

“Well, I’m not sure whether your creditors would do that, but, let’s assume that they would. That then causes a lot more problems. Specifically, tax problems.”

“Tax problems? We pay our taxes every year. We even get a small refund. What ‘tax problems’ are you talking about?”

“I’m talking about Section 108 of the Internal Revenue Code. Congress laid down a general rule that forgiveness of debt is income.”

“I don’t understand.”

“Not understanding Congress seems to affect most Americans. So let me explain the tax rule to you.

“Congress decided that, if a person negotiates with a creditor for forgiveness of debt, the amount which was forgiven must be included as income in your income tax return. For example, if the bank wrote off $40,000 on your lake property, then you’d include an additional $40,000 on your income tax return. In your situation, your income would increase from $65,000 to $105,000. Your income tax bracket would rise, and you’d pay taxes on that increased amount.”

“That’s nuts!”

“That’s Congress.”

“Are there any exceptions?”

“There are a few. For example, if the bank would reduce your mortgage balance on your home, then any forgiveness of debt is not included in your income. However, that exception is only valid until December 31, 2013. And, if you file for relief in bankruptcy, then the discharge of the debts is not income.”

“Let me see if I understand this. Except for my principal residence, I have to pay taxes on forgiveness of any part of a debt. But, if I file for bankruptcy, and get rid of all of my debt, then I don’t have to pay any additional taxes when all of the debts are discharged in bankruptcy.”

“You’ve got it. It’s goofy, but it’s the law.”