Many of our clients meet with us at Steidl & Steinberg and tell us about the stories they've heard.
Their friends, or friends of friends, or friends of friends of friends, have “settled” their debts, or have given back or had a “short sale” or their house, or a creditor has “forgiven” the debt that was owed to the creditor. The IRS is now coming after them for income taxes that are owed from the year that the event occurred, sometimes for thousands and thousands of dollars. What is this all about?
It is about debt forgiveness and, yes, the IRS will get involved and try to recover taxes for cases where debt was written off.
Here are some examples of "debt forgiveness."
1.The client has worked with one of the out-of-town debt settlement companies and has settled their $50,000 in debt for $30,000, a savings of $20,000. The amount forgiven, $20,000, is treated as regular income for tax purposes, just as if the client had earned in in her job. Since she was in the tax bracket after this income was added, the amount of additional income tax she owes is $20,000 times 28%, or $5,600 in additional taxes. This means that the settlement of her debt was really $30,000 plus $5,600, or $35,600, a savings of $14,400, and not $20,000.
2. The clients owned a house worth, they thought, $250,000, but they were unable to sell it at that amount. They finally received an offer of $210,000 after it had been on the market for a year. Problem is that they owed $230,000 on the mortgage, so the only way the sale was going to go through is by a “short sale”. A short sale is when one or more of the entities who was entitled to get paid in full from the closing is not paid in full because there isn’t enough money to pay them. While there is a balance of $230,000 left on the mortgage, the mortgage holder will only receive approximately $190,000 from the sale proceeds. In this example, the mortgage company accepted the short sale. The mortgage company could go after the former homeowners for that amount, but often just forgives the deficiency, which is this case was about $40,000. This means that the sellers now had $40,000 more income to declare on their taxes. If this put their income in the 33% tax bracket, they now owe an additional $13,200 on their income tax bill.
3. The credit card creditor was after the client for payment of a $17,000 credit card bill for years. Finally the creditor gave up and forgave the debt. The client was surprised this happened, but was saddled with the additional income $17,000. That bumped him up to the 25% tax bracket, so he needed an additional $4,250 to pay the IRS.
In most cases, if you can file your bankruptcy on time (and let our Steidl & Steinberg determine when on time is), you will be spared those taxes. In each of the above situations, if the client or clients had filed their bankruptcy before the end of the taxable year when the forgiveness occurred, the IRS will not be able to add income taxes for the debt forgiveness. Better yet, if the forgiveness has not yet occurred, as in the vast majority of credit card debt, there are no forgiveness issues to worry about. You may have $50,000 in credit card debt, it may all be discharged in a bankruptcy, and there are no taxable consequences at all.
So don’t let life be so taxing, and don’t listen to your friend or your friend of your friend or your friend of your friend of your friend. Listen to Steidl & Steinberg.