Bankruptcy and Non-Bankruptcy Alternatives For Different Types of Debts
There are many different kinds of debts and bills.
There are mortgage, credit card, taxes, student loans, payday loans, alimony, child support, as well as debts that might come from negligence or other actions, and many more.
People who find themselves unable to pay their debts are often confused about their options.
Not unexpectedly, the options vary depending on a number of factors.
I have divided the different options into two main categories: Bankruptcy and Non-Bankruptcy.
- Debt Consolidation
- Debt Settlement/Negotiation
- Do Nothing
- Repayment Plan (Chapter 13 and Chapter 11)
- Liquidation (Chapter 7)
Non-Bankruptcy Debt Resolution Options
These are options you can take other than filing for one of the different types of bankruptcy.
Debt consolidation is just a new loan that you take out to pay off all your other (usually credit card) loans.
Thus, no settlement involved here.
The main benefit is you consolidate your multiple different payments into one big one.
But do you save any money?
Debt consolidation companies advertise this as a way to get lower payments.
It depends on the terms of the loan, which usually start out with a teaser interest rate, but then increases and leaves you with a much higher payment.
But even at its best under the most optimal terms, the debt consolidation leaves you paying off all of your debts.
If you can afford to do that, that’s wonderful.
But what you’re really doing is simplifying rather than reducing your debt load.
This is not a real solution to debt problems.
It’s really aimed at people who are too disorganized to make multiple payments or negotiate with multiple creditors.
It just moves the debts from one source to another, and adds a new layer of costs (the amount you pay for a debt consolidation can be very high).
If you plan to use this option, be sure to run all the specifics by your accountant or professional financial adviser before committing, and compare all other options first.
Creditor Settlements and Negotiation
This is simply trying to work out payment plans with your creditors.
Usually this takes the form of trying to get a reduction in the total amount owed and/or interest rate, and then either paying it off in a lump sum, or over time.
Sometimes this can work, and the negotiated discounts can be 50% or more, but usually it requires that you be delinquent (in default) on your payments for many months, if not years, before a meaningful settlement can be reached.
This causes significant damage to your credit score and, if you’re not able to reach agreements with ALL your creditors, then your credit will continue to be affected despite the other settlements.
Tax Consequences of Debt Settlement
When you settle a debt, there is a corresponding forgiveness (cancellation) of the unpaid balance by the lender (or whomever you currently owe the debt to).
And guess what: Cancellation of debt is taxable!
That’s right. You can end up with a whopping tax liability for settling your debts.
Of course it depends on the amount being cancelled as well as your personal tax situation (what deductions you have for that particular year, etc.), but the risk is there.
So be sure to discuss the specifics of your debt settlement plan with your accountant before doing anything.
So usually this is beneficial if you only have one or two creditors, with relatively small amounts owed, and you have the ability to make a lump sum payment to settle everything.
The Do Nothing Approach
Don’t laugh, this is sometimes a legitimate option.
If you do nothing, eventually some or all of your creditors will file a lawsuit, and obtain a default judgment against you in court.
A court judgment will enable them to take whatever collection actions are allowed by the laws of your state.
Usually this includes things such as wage garnishment, bank account levies, and liens against property, such as your home.
Some people, however, are basically judgment-proof.
They have no assets and no income or the income they have is protected (such as social security or certain retirement income) and expect to remain that way for the remainder of their lives.
For them, doing nothing might well be a viable and inexpensive option.
Although see my article on why even the judgment proof people may benefit from bankruptcy.
Or, there is another often superior option. . .bankruptcy
Bankruptcy allows you to restructure or eliminate your debts, usually on far better terms and at far less expense than you would achieve outside of bankruptcy.
And the creditors are required to accept what they get (or don’t get) in a bankruptcy case.
You don’t have to worry about them “backing out” of their agreement or using some loophole to later revive the debt or cause you other problems.
You are protected by federal law in a bankruptcy case.
Bankruptcy Can Accomplish The Same Or More, At Lower Cost, With No Tax Liability
What if I told you that you could accomplish the same thing as a debt settlement, possibly on better terms than you could get by negotiating with your creditors, at a lower cost, and not have it result in any tax liability from the debt cancellation?
What if you could do it without having to pay anything to your creditors?
Would that be of interest to you? Sure it would. And you can.
Bankruptcy allows you these options. Whether you would need to pay anything and, if so, how much, depends on the specific facts of your situation (your assets, debts, income, expenses) and which Chapter under which you are eligible to file.
Chapter 13 allows you to make payments, anywhere from 0-100% of the debts, depending on your budget.
In a Chapter 7 you would not have to make any payments.
But either way, you would not end up with any tax liability, as long as you file the required Tax Form 982 after you receive your bankruptcy discharge.
That’s because the Internal Revenue Code has a special provision (section 108) which excludes debt canceled through discharge in bankruptcy from being taxable income.
Certain tax attributes, such as operating loss carryforwards, may need to be reduced, but you won’t owe any taxes.
But as is often the case, bankruptcy offers the most favorable terms for eliminating or reducing your debts.
Always Speak With A Bankruptcy Attorney To Learn All Options Before Deciding
The biggest mistake people make is not including bankruptcy in their arsenal of options when examining how to deal with their debts.
They feel it is a “last resort”, when quite to the contrary, for many it should be a first resort.
Of course it depends on your specific situation, but it usually costs nothing to get the preliminary advice of a bankruptcy specialist.
Doing so can save you a lot of money and heartache.
Effect of Discharged Debt on Taxes
Image by Jeff_Golden