Debt forgiveness can be a major benefit to a person who is struggling with credit card and other large debts. However, it can also negatively affect your credit score. Some creditors offer debt-forgiveness programs, as do credit counseling services.
Types
Debt forgiveness can come in a number of different ways. Credit cards may offer those who have fallen behind on their payments an opportunity to get caught up by offering to accept a smaller amount to pay off the balance. Mortgages may be restructured or foreclosed on, with at least some of the debt being forgiven. Generally, debt forgiveness on a secured loan will likely mean forfeiture of the asset used to secure the loan.
Features
If the entire debt has been forgiven, then the account in question will likely be closed, especially if it is a revolving account. Chances are charge privileges will already have been suspended if the debt is on a credit card. If only a portion of the debt is being forgiven, the individual will likely need to pay the outstanding amount in full before the cancellation of the remainder of the debt becomes effective.
Misconceptions
Some people mistakenly believe that if a creditor approaches them and offers a settlement or debt cancellation, the issue cannot be reported to credit agencies or affect their credit ratings. This is not true. Any debt obligation that is not fulfilled on the original terms could possibly be seen as a bad debt. While settling or canceling a debt is better than a default, either process will likely have a negative affect on your credit rating.
Taxes
Tax liability is another important aspect to consider before accepting any debt settlement. If the canceled debt is worth $600 or more, creditors must file a form with the IRS. The amount of the canceled debt will then be counted as income by the IRS and therefore be subject to taxes. Those who do not account for this in their payroll deduction may have a surprise at the end of the year. Not counting your canceled debt as income on your tax return could result in an audit.
Exception
The main exception to the tax liability on debt forgiveness is when the debt forgiveness is part of a mortgage. This has not always been the case, but the Mortgage Debt Relief Act of 2007 changed the law regarding tax liability. In order not to be taxed on the forgiven debt, the mortgage must be on a principal, owner-occupied residence. As of September 2009, the law affects debt forgiven between 2007 and 2012.
Student Loans
In some cases, student loans will be forgiven without any effect on a person's credit. This is especially true for teachers and medical professionals who agree to serve a number of years in underserved areas.
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