What do you mean I earned $4,000 when they repossessed my car?

So what happens after a car is repossessed and if the loan is forgiven ... or any loan is forgiven and what can the debtor do about it? This is a continuation to my blog post "Did you know a short sale of your home could create income for you? ... but not this year ..." http://bit.ly/14IJuLM.

Image courtesy of Toa55 at FreeDigitalPhotos.net

Normally, if a car is repossessed, it is worth less than the amount of the loan... it is underwater or upside down. The lender takes the car, sends it to auction and the sells it to the highest bidder. If the borrower had a loan on the car for $30,000 and the car sold at auction for $21,000, the borrower may still owe the lender $9,000. Many people think after the sale the car, the case is over. But in many cases, it is not. The lender may seek payment for the additional money. They can seek a "deficiency judgment."

Before this happens, a borrower can try to negotiate a voluntary repossession and ask the lender to forgive the deficiency. The second option is to pay the outstanding debt after the sale or the borrower can just ignore it ... for awhile. Finally, the borrower can negotiate to settle the remaining debt.

The point of this post is to talk about the consequence of debt forgiveness. So what happens if this debtor settles his deficiency debt for $5,000. That leaves a debt of $4,000, which is forgiven by the lender. Under the US tax code, the lender has to report that debt forgiveness/cancellation as income on a 1099-C to the debtor.

Let's also assume this debtor chose that year to clean up all his debt. So he settles $24,000 of additional credit card debt for $14,000 cancelling another $10,000 in debt. The result is the debtor will be credited $14,000 additional income for the year and pay more in income tax as well as what was paid to settle the debt.

One of the ways to avoid this credit is to file for bankruptcy and discharge the debt instead of settling it. In bankruptcy, a person can surrender a car and discharge the deficiency before it becomes income. A debtor would also discharge some or all of the credit card debt depending on the circumstances.

Another possibility in a case like the one described above would be to discharge the credit card debt possibly enabling the debtor to be able to pay for and keep the car. If the debtor has enough income to pay back part of the debt, he could file for Bankruptcy under Chapter 13.

By filing under Chapter 13, the debtor's income and budget would dictate the amount of payments creditors receive and not the creditors whim. A debtor not only avoids the debt he is unable to pay but the additional tax as well. I suggest bankruptcy offers the most protection and flexibility to debtors truly in over their heads in debt.

If you want assistance, legal representation, or just want to know more about Medvesky Law Office, LLC, check out our website at www.medveskylaw.com.

Other articles to read:
1099-C surprise: IRS tax follows canceled debt - http://bit.ly/1FHFcEQ
6 exceptions to paying tax on forgiven debt - http://bit.ly/1xRHqvJ
Canceled debt tax notices riddled with problems, advocate says - http://bit.ly/17ygHL5