When your debt becomes unmanageable, you may be facing bankruptcy or a home foreclosure. No matter how you got to this point, the goal now is to get out from under the debt and start rebuilding your credit. Occasionally, a bank or a creditor will offer to "forgive" all or a portion of your outstanding debt. When this occurs, it's beneficial, but you may discover some pitfalls as well.
Function
Debt forgiveness indicates that the creditor is willing to write off your debt. While this is not the first option, it offers the creditor a way to deduct their financial loss against their annual profits when they file their income taxes. In addition, it may offer you the chance to avoid a bankruptcy if it lowers your debt to a manageable amount.
Types
Any bank or creditor can offer debt forgiveness to a borrower who demonstrates that he cannot repay the debt. Credit counseling services may make a deal with credit card companies for you to pay a small amount of the bill before the creditor cancels the rest of your debt. Mortgage debt forgiveness occurs when the bank allows you to sell your home for less than what you owe (short sale) and then cancels the remainder of your debt. In short sales, the bank may take an active role in negotiating the home's sale price.
Benefits
Stopping a foreclosure is a big relief for most homeowners who are upside down in mortgage debt. In addition, debt forgiveness puts an end to collection agencies sending notices and calling. Once a creditor makes a deal to settle your outstanding debt, they will no longer report your delinquency to the credit bureaus.
Taxes
Unfortunately, debt forgiveness isn't without problems of its own. Since the creditor will file your canceled debt as a loss, the IRS requires them to supply a 1099-C, Debt Cancellation Form, with their taxes. After the first of the year, you will also receive a 1099-C form that you must include when you file your personal income taxes. Because the IRS views the forgiven debt as a financial benefit to you, you may have to pay income taxes on the amount.
Legislation
The Mortgage Forgiveness Debt Relief Act, passed by Congress in 2007, offers relief for homeowners who must sell their homes at a loss because of the national housing crisis. Through 2012, homeowners who benefit from mortgage debt forgiveness will not pay income taxes on the canceled amount. After 2012, the homeowner should contact a tax attorney or an accountant about the tax ramifications of a forgiven mortgage debt.
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