Anyone who has racked up a lot of debt knows that if they go into default, they can be at the mercy, or lack thereof, of their creditors.
For example, as a tool to try to convince you to just give in and pay the debt, a creditor or credit collection agency can threaten a forgiveness of the debt. Now while you think this might be a good thing, it has two major impacts on your financial life of which you need to be aware.
First, forgiving a debt, especially a debt that is a coupe thousand dollars or more, will wreak havoc on your credit rating. To have a debt forgiven is worse than settling a debt. In a debt settlement, there is a partial forgiveness of the debt, as the creditor is agreeing to accept less than the debt’s actual amount and is writing off the rest.
But the darker side of this awaits you come tax season the following year.
If the forgiven debt is more than $600, or if the debt was settled for more than $600 less than what was owed, that amount is taxable as income. For many who settle their credit card debts, this will typically mean an extra couple hundred dollars added to their tax burden, resulting in a shrunken tax refund, or an increased amount owed. It will not have a significant impact on your taxes, and if you do end up owing as a result, the IRS will work with you to make arrangements to get everything paid if you cannot pay it at the time you file.
But let’s turn our attention to something a little more… significant.
Over the last couple years, to say there have been so many foreclosures on mortgages that a fleet of merchant tankers cannot contain all of them might seem accurate. To avoid foreclosure, many lenders are accepting an alternative: a short sale.
When a house is sold short, the bank agrees to take whatever can be gotten for the house and write off the rest. There are certainly some hurdles involved, and if you are looking into buying a home being sold short, speak with an attorney to find out what you’re in for.
When presented with a short sale, the lender will tend to go with it because it gets a potentially bad loan off their books. But the difference between the principal and the revenue from the sale is considered a canceled debt. This means this amount is also taxable. And given we’re talking about real estate, you can almost guarantee that there will be a taxable amount left over.
This amount will jump you a few tax brackets, and may erase your ability to take certain credits and claim certain deductions. You might even find yourself subject to the dreaded Alternative Minimum Tax.
Basically short sales mean both the lender and the borrower take a significant financial hit. I wonder if Congress and Obama are taking this into account.
This really makes me wonder how many families are finding themselves with “upgraded” incomes in the eyes of the IRS because of debt settlements or short sales.