Student Loans

What Happens When a Lender Forgives a Debt?

Not that long ago, we talked about the perils of co-signing for a student loan for someone headed off to college. In that article we focused on the examples of families asking (without great success) to have the loans they co-signed for their children forgiven when those children had died. And that whole concept of loan forgiveness – whether it’s a student loan that you co-signed for, or maybe your own student loan, or credit card debt or any other type of consumer debt you may owe – got me thinking. What do you need to do if you’re considering this and what are the long-term ramifications?

Suppose you (or someone you know) are not able to pay back a credit card or some other type of consumer loan. (And that is something that is becoming more common, as there is still high unemployment and people burdened with a lot of debt). If you negotiate with your creditor and get them to either forgive or reduce the debt (and let you settle for an amount less than you owe), there are additional financial and other implications for you to consider.

First of all, if a creditor writes off your debt completely, it will go on your credit report (and stay there for 7 years). They may also sell your unpaid debt to a third party collection agency and no one wants to be on the receiving end of the aggressive tactics that most bill collectors use. If they settle your debt for less than you owe, it will still show up on your credit report.

But here’s the thing that the creditors are probably not going to tell you. When a creditor either writes off the debt you owe or agrees to settle the debt with you, the amount owed (whether it’s the full balance or the amount they wrote off) is considered taxable income  (if it’s more than $600) by the IRS and, most likely, the state government and you’ll have to pay taxes on it.

You’ll eventually get what’s known as a 1099-C Cancellation of Debt form from the creditor and the forgiven debt will need to be reported as income on your federal and probably state tax returns. And there’s virtually no chance a creditor won’t report the forgiven debt to the IRS because doing so will lessen their own tax burden since it’s income they didn’t recognize (because you didn’t repay it).

If you were to choose to file bankruptcy, you would not owe any money to the IRS on any debts wiped out through the bankruptcy proceeding.

And now back to the student loan example I started with. The New Jersey reporter, Karin Price Mueller of The Star-Ledger, who wrote about the issue of financial institutions going after parents who had co-signed student loans for their deceased children, noted in the same article that some of these same financial institutions were sending 1099-C forms to the parents (or other co-signers) of these loans. Ms. Mueller correctly points out that there is a Treasury regulation that specifically provides that the guarantor (otherwise known as the co-signer) of the loan is not responsible for the debt and that a 1099-C should never be issued to a co-signer.

Sometimes bad financial things happen to good people and, even with all the best of intentions, folks can’t pay off their debts. If you’re considering – or you know someone considering – asking a creditor to settle for less or wipe out the debt entirely, just remember that there’s still money that will be owed. It will just be owed to the IRS now, instead of the creditor. That’s an important thing to remember.