April 2010

Debt Negotiation vs. Bankruptcy

Christina Latta Henry |  | Bankruptcy

I often have clients come to me and ask me to help them renegotiate their debts without filing bankruptcy. In many cases I can and do help people reduce the principal amounts they owe to their creditors through direct negotiation. One important thing a lot of people don’t realize, though, is that the IRS treats debt cancellation as taxable income if the debt was not forgiven through the bankruptcy process. If you owe your bank $60,000 and negotiate with them to reduce the principal to $40,000, the bank will send you a Form 1099-C reporting $20,000 of canceled debt, and you will have to report that $20,000 as income and pay taxes accordingly. That can lead to a nasty surprise at tax time!

By contrast, debt that is canceled through bankruptcy is not considered income and you do not have to pay taxes on it. If you’re in a position where you can’t pay your creditors, filing bankruptcy can help you as much as or more than independent debt negotiation, and also provides you with a host of legal protections and benefits that you won’t otherwise get.

Note that debt cancellation is not the same thing as interest rate reduction through credit counseling, which does not have any effect on your taxable income.

For more information, read our article Is Debt Negotiation Right For You? For more about canceled debts and taxes, see IRS Publication 4681: Canceled Debts, Foreclosures, Repossessions, and Abandonments.

The Elephant In the Room

Christina Latta Henry |  | Bankruptcy, Current Events, Foreclosure

With bank seizures of foreclosed homes at record levels, the Obama administration continues to treat bankruptcy court as the proverbial elephant in the room. As this New York Times editorial observes, the administration’s Pollyanna-ish belief in the willingness of banks to voluntarily modify principal balances for homeowners facing foreclosure has led to a standoff between primary and secondary mortgage holders:

Investors, including pension funds and mutual funds, often hold the first mortgages. Banks often hold home-equity loans and other second mortgages. Investors reasonably believe that second liens should be reduced before the primary mortgage is modified, but banks balk at that because it would prompt write-offs they don’t want.

Fortunately, investors are getting tired of this foot-dragging:

Some investors, notably the powerhouse group BlackRock, have called for a special bankruptcy process to resolve the standoff. The court would seek to reduce bankrupt borrowers’ total debt to affordable levels, starting with unsecured debt like credit cards, then undersecured debt, like second mortgages, and then, if necessary, the primary mortgage debt.

Giving bankruptcy judges permission to modify the terms of mortgage loans–isn’t that what we’ve been saying for years? Maybe this time the message will get through to Congress and the administration.