Credit card debt is only reduced when a settlement between borrower and lender is reached. This can occur through bankruptcy, debt repayment plans, and debt forgiveness. The law requires that the reduction in credit card debt be taxed as income.
Bankruptcy Laws
Personal bankruptcy has two forms, Chapter 7 and Chapter 13. Chapter 7 involves liquidating your assets and then using it to pay off all debts, including credit card debt. In Chapter 7 bankruptcy, the law requires credit card debt to be paid off with available funds. If the creditor gets a reduced amount than was originally owed, they accept that lost as the debt is discharged. Chapter 13 bankruptcy involves a repayment plan to all creditors. Credit card debt may be reduced with the elimination of fees and penalties, but the debt is still owed. Credit card debt reduction through bankruptcy is not taxable as income. Credit card debt for non-business expenses is also not taxed if it was included in a Chapter 11 business bankruptcy.
Laws on Reporting Reduction in Debt
If a debt is reduced or forgiven outright, the lender files a 1099 form. Forms 1099A and 1099C are used to report partially or completely forgiven debt. In most cases, the amount by which the debt was reduced or forgiven becomes taxable.
Mortgage Forgiveness Debt Relief Act
The Mortgage Forgiveness Debt Relief Act was passed in 2007. While debt reduction or forgiveness is generally taxable, the first $2 million of debt for first mortgages forgiven between 2007 and 2012 is not taxed. However, this law does not affect the taxability of credit card balance reduction through debt settlement. As of 2010, there was no equivalent debt relief act for Americans in credit card debt.
Bankruptcy Abuse Prevention and Consumer Credit Protection Act
The Bankruptcy Abuse Prevention and Consumer Credit Protection Act was passed in 2005. This law requires credit counseling for those who file bankruptcy for any debt, including credit card debt.
Legal Process for Debt Settlement
Credit card debt reduction only occurs after a settlement is reached and agreed upon by both parties. The consumer can offer a settlement for partial payment of credit card debt. The lender or collection agency can offer a settlement as payment for the outstanding credit card debt. If a debt reduction amount is not agreed upon, the original debt remains outstanding. If the consumer cannot settle the debt for a reduced amount, they can be sued for the entire amount in small claims court.
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