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Debt Forgiveness Always Has a Catch

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A husband and wife are sitting in their home looking over their finances and are working on their retirement plan.

The Credit Card Debt Forgiveness Act and the Obama Student Loan Forgiveness Program don’t exist. The IRS won’t erase your tax debt just because you say you can’t pay it.

Even when debt forgiveness options are available, they can be loaded with traps such as hard-to-follow rules, unexpected tax bills and damage to your credit scores.

You need to know all this because there’s a thriving industry of scam artists telling you otherwise. In their ads and email come-ons, the bad guys try to convince people drowning in debt that there are ways to escape without serious consequences.

Yes, some debts can be forgiven, but there’s always a catch. Knowing what those catches are can help you decide whether absolution is something you really want to pursue.

Student loan forgiveness

Programs that forgive, cancel or repay education debt have been around awhile. Typically, the plans require borrowers to work in public service or specific professions such as teaching or health care in high-need, low-income areas. Other borrowers can get relief through certain volunteer programs or serving in the military.

What changed under President Obama’s watch — and what presumably gave rise to rumors about an “Obama Student Loan Relief” program — was the extension of forgiveness to struggling borrowers regardless of their profession. Payments are reduced to reflect a borrower’s low income, and remaining balances are forgiven after 20 to 25 years of payments. (Read “4 Ways to Get Student Loan Forgiveness” for details.)

The long repayment term, however, means some could pay more on their debt even with forgiveness than they would over a typical 10-year term.

Also, debt that’s erased under this and some other programs — such as employer-paid loan repayment assistance or student loan cancellation because of death, disability or school closures — is considered income to the borrower, says financial aid expert Mark Kantrowitz. So absolution comes with a tax bill.

 
More on reducing and eliminating debt

Bankruptcy and debt settlement can reduce or eliminate credit card debt, but they severely impact your credit. Debt management reduces interest rates, and its effect on your credit is less severe. Debt consolidation can reduce interest rates as well.
Reduce your debt in four steps: 1. Get a handle on what you owe. 2. See how much you can pay over the minimums. 3. Consider options such as payoff strategies and debt consolidation. 4. Track your progress.
Debt forgiveness is when a creditor agrees to cancel part or all of what you owe. But you should be aware that the IRS generally regards forgiven debt as income. You may want to consult a tax professional about additional tax obligations you’ll be taking on if you settle your debt.

 

Debt erasures tied to specific jobs or careers don’t trigger taxes. But forgiveness still requires attention to rules and details. Public Service Loan Forgiveness, for example, makes sense only if you opt for an income-driven repayment plan, and those require annual recertification, says NerdWallet student loan expert Brianna McGurran.

“The promise of forgiveness can let you pursue a career you love despite huge student loan debt, but you won’t get it if you don’t follow the rules,” McGurran says. “Make sure you understand all the nitty-gritty details of the forgiveness program you choose, and check in with your student loan servicer regularly to make sure you’re on track.”

Credit card debt forgiveness

Credit card issuers can and do forgive balances as part of debt settlement. If an issuer thinks you’ll file for bankruptcy or otherwise won’t pay your bill, it may decide some money is better than none.

But as with much other forgiven debt, the amount you don’t pay can trigger a tax bill.

You also have to count on damage to your credit scores, since few issuers will negotiate with you if you’re current on your bills. You typically have to be three months or more overdue, which wreaks havoc on your credit scores. If your creditor sues you, then you would have to deal with judgments — another credit score killer — and perhaps wage garnishment.

Even if you succeed in getting a settlement, the settlement itself can deal another blow to your scores when it’s reported to the credit bureaus.

Most people are better off filing for Chapter 7 bankruptcy than exposing themselves to the debt settlement process, says John Rao, attorney for the National Consumer Law Center. Bankruptcy filings halt collection actions and lawsuits, and a Chapter 7 filing can legally erase debts while ending garnishments. “All the harassing phone calls and everything else that goes on just stops,” Rao says. “It’s a fairly quick process, and the consumer gets relief immediately.”

The debt settlement process can grind on for months, if not years, and creditors may not cooperate, Rao says. That’s assuming the debt settlement company even tries to help. “So many of these operations aren’t legitimate. They’re scams,” he says. “Even if they are legitimate, it’s just very difficult to get relief.”

Unlike settlement, bankruptcy doesn’t trigger a tax bill, and it can even help your battered credit scores recover sooner.

Mortgage debt forgiveness

Mortgage lenders charged off more than $1 trillion of home loans between 2007 and 2014, according to the Federal Reserve. Charging off isn’t the same as forgiving, though. It’s an accounting term that indicates lenders didn’t think they could collect what they were owed.

Some lenders tried collecting from displaced homeowners after foreclosures and short sales failed to cover what the borrowers owed. Often, though, lenders canceled the remaining “deficiency balances” — which generated a potential tax bill for the borrowers.

The Mortgage Forgiveness Debt Tax Relief Act of 2007 allowed taxpayers to avoid recognizing this income, and having to pay taxes, on debt forgiveness related to their primary residence. This act has been extended four times and now applies through the end of 2016.

To get this forgiveness, though, homeowners typically had to go through the hell of losing their home and suffering severe damage to their credit scores. If you have an unaffordable mortgage, consider using one of two government programs: the Home Affordable Refinance Program (HARP) or the Home Affordable Modification Program (HAMP). HAMP is scheduled to end this year and HARP will end in September 2017, so don’t delay.

Tax debt forgiveness

Here’s a little bit of good news: If you succeed in getting tax debt forgiven with what’s known as an “offer in compromise,” you won’t face a tax bill for the forgiven debt.

You have to be pretty hard up for the IRS to give you a break, though, since the agency has so many ways to collect what it’s owed. The IRS can hold on to your refund, take a chunk of your pay, put a lien on your bank account, seize and sell your property and revoke your passport. Uncle Sam also can take 15% of your Social Security check, a benefit that’s off-limits to private creditors. The IRS accepts offers in compromise only if the agency believes it has no better way to collect more of the money it’s owed in a reasonable length of time, tax experts say.

“The taxpayer has to be nearly insolvent,” says Cari Weston (no relation), director of tax practice and ethics for the American Institute of Certified Public Accountants. “That means little to no assets.”

If you do have assets, the IRS expects you to sell them and send it the money. That includes homes and retirement funds, even if tapping those funds would generate taxes and penalties, she says.

To submit an offer in compromise, you also have to bare your financial soul. You must disclose the value of all your major assets, all your sources of income and all your expenses, says Mark Luscombe, principal analyst for tax and accounting at Wolters Kluwer, an information services company. (You can get a taste of what’s involved using the IRS’ offer in compromise pre-qualifier tool.) If your offer is rejected, you can’t take back all that information.

“The IRS now has a road map as to all of the taxpayer’s assets and income for further collection activity,” Luscombe says.

Many people who have trouble paying their tax bills would be better off asking the IRS for an installment plan, Weston says. Those who owe less than $10,000 get automatic approval. Those who owe $10,000 to $50,000 can use a streamlined process that typically allows them to pay the balance over six years.

Exploring these options first makes a lot more sense than paying an offer-in-compromise firm an upfront fee of $2,500 or more in exchange for a low chance of success, she says.

Plus: “That means the IRS knows you had $2,500,” Weston says, “and they’re going to wonder why you didn’t apply that to your debt.”

Liz Weston is a columnist at NerdWallet, a personal finance website, and author of “Your Credit Score.” Email: lweston@nerdwallet.com. Twitter: @lizweston.