Can I Claim Bankruptcy on a Credit Card Debt Cancellation?
Settling credit card debt is a little known but perfectly legal option for borrowers who are delinquent and struggling. Although these borrowers can eliminate thousands of dollars in debt by negotiating, the amount that's forgiven is added to personal income and is taxed by the Internal Revenue Service. Avoiding this tax is possible by declaring insolvency at tax time; while bankruptcy eliminates this tax as well, the petition should be filed before the debt is settled.
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How Bankruptcy Works
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When it comes to credit card debt cancellation, many borrowers confuse bankruptcy with insolvency. Debtors don't "claim" bankruptcy; they petition the federal bankruptcy court for permission to declare Chapter 7 or Chapter 13 bankruptcy. Chapter 7 or "straight" bankruptcy requires petitioners to pass a means test to qualify. It also requires the petitioner to sell assets, the proceeds of which are used to repay creditors. Chapter 13 or "reorganization" bankruptcy allows the petitioner to repay debts over a period of time ranging from three to five years. Petitioners don't repay credit card debts prior to bankruptcy because these debts are usually eliminated; once the debts have been paid, it's too late to include them in a bankruptcy petition. Cancelled debts are reported to the petitioner on tax Form 1099-C and are reported to the Internal Revenue Service on Form 982.
Insolvency
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A taxpayer who settles a credit card debt but did not and will not declare bankruptcy may "claim" insolvency if her liabilities exceeded her assets immediately prior to the date the debt was cancelled. If she is insolvent, then the cancelled debt is not added to income by the IRS and is not taxed. There are other debt exclusions as well; Title 11 bankruptcy, farm indebtedness and real property business indebtedness are excluded. Claiming insolvency to avoid taxes on debt cancellation requires the taxpayer to submit Form 982 with their annual tax return. Form 982 is complicated; the IRS recommends that taxpayers who wish to declare themselves insolvent hire a tax adviser to complete the form on their behalf. Insolvency does not require the debtor to file paperwork with federal court.
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Ramifications of Debt Cancellation
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Canceling debt and declaring bankruptcy each have serious and potentially lifelong effects on a borrower's personal credit history. Late payments make up approximately a third of your credit score, which is the number that lenders, insurers and possibly employers use to determine the level of risk you present them. Late payments stay on credit reports for seven years; bankruptcies stay for 10 years -- and may appear forever to potential employers if you work for certain employers or earn above a certain amount. Insolvency does not appear on a borrower's credit report, but lenders usually require borrowers to be several months behind on payments before they'll consider settling; as a result, late payments appear.
Recovering from Bankruptcy, Insolvency and Indebtedness
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Although personal indebtedness is undoubtedly stressful, it is possible to recover over a two- to three-year period. To improve your financial and credit standing, always pay your bills on time and preferably in full because late payments and amounts owed make up about two-thirds of your credit score. In addition, don't take out too many loans at once, and try to keep a mix of loans in your portfolio. Home loans are the best quality loan, followed by car loans and credit cards, respectively. And if you're considering negotiating your debt, contact a credit counseling agency who can advise you -- often, for free -- on settlement versus bankruptcy.
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