Warning! There is a hidden trap in debt forgiveness you must be aware of
Beware! Forgiveness of debt converts to ordinary income and may be taxable! If you were unaware of this issue, you would find out about it in January when you get a forgiveness of debt 1099 for the amount of debt forgiveness you negotiated, and find yourself uttering the worst word in the dictionary: Oops!
Clearly, a major focus of the services I provide to my clients is debt workout, SBA loan forgiveness, and bank debt forgiveness of debt owed. We have negotiated hundreds of millions of dollars of forgiveness of debt and understand the issues and problems. Therefore, I provide you with the following warning: The forgiveness of debt is considered ordinary income by the IRS and could leave you with a substantial debt now due to the IRS instead of to the bank or whomever the original debt was with. This is a lot like the proverbial “jumping from the pot into the fire”.
Owing the IRS can be a daunting experience and a very expensive one. The interest and penalties can be huge and compound rapidly. Additionally, if a few borrowers are guaranteeing a loan, let’s say for one million dollars, and they negotiate forgiveness for the entire amount, the IRS will deem each guarantor liable for the full one million of forgiveness, as each person was liable for the entire amount, (individually and severally guaranteed is the term). That means each borrower guarantor could be looking at $300k-400k of IRS debt for the debt forgiveness granted. Ouch.
What can be done to avoid this? A number of strategies do exist which will eliminate the threat of debt forgiveness being converted to ordinary taxable income. While some are difficult strategies to implement, they work very well and must be considered. The good news is that the most common way around this issue is simple and is almost automatic. It is, of course, based on the facts of each situation, but the point is one must be aware of the issue first and then find a way to resolve this issue as well as the original debt.
There is a significant exemption from this situation recently passed by the Mortgage Forgiveness Debt Relief Act of 2007. As stated therein, any debt forgiveness associated with your principle place of residence is NOT subject to forgiveness of debt 1099 ordinary income treatment! This includes debt forgiveness from refinancing or selling your principle place of residence and is a very important exclusion. There are other major strategies that remove this possibility and which have broad application to many borrowers.
If your loan workout representative is not talking about this issue, he may not be experienced in this area and you should consider replacing him with a more experienced representative. If your representative is telling you this is going to happen but does not have a solution, also change representation, as he is not experienced enough to represent you effectively. Call me if you are confronting this matter before you resolve the debt. After the fact may be too late to resolve the ordinary income issue resulting from a loan workout effort.
Forgiveness of debt is an important result and is available for an SBA loan in default. However there are many pitfalls along the way that only an experienced workout specialist can resolve or even be aware of. This is too important a matter to allow inexperienced professionals figure it out.
