Debt

In a world of uncertainties, two things are clear, debt is rampant, and it’s tax season.

Let’s look at how various types of debt relief affects taxes:

How Loan Refinancing Affects Taxes

Refinancing isn’t always in a debtor’s best interest but can make a lot of sense depending on the financial circumstances. While we won’t get into the weeds on how every refinancing situation affects taxes, rest assured that the answer is usually a positive one. For example, you can extend your mortgage’s tax-deductible interest payments even further by refinancing to pay off other types of debts, like credit cards.

Similarly, whether you’re paying a student loan or refinancing one, the interest you’re paying is also tax-deductible up to $2,500.

How Deferment and Forbearance Affect Taxes

It’s common to have a bloated student loan debt these days. Fortunately, student loans carry more consumer-friendly options than other types of debt. If you’re struggling to keep pace with your student loan, a deferment or forbearance allows you to temporarily stop payments for a period of time and get back on financial track. Thankfully, you can still receive your tax refund if your student loans are in deferment or forbearance.

How Debt Settlement Affects Taxes

When debt has surpassed manageable levels, many people turn to debt settlement services for help. These companies negotiate with creditors to reduce an overall balance. According to Freedom Debt Relief FAQs and reviews, debt settlement providers charge a percentage fee based on the amount of debt they’re able to eliminate, but only after a debtor has agreed to pay the reduced sum.

Not every financial institution will negotiate with debt settlement companies, but the model has proven to be relatively successful. If you’re considering opting for debt settlement to leave your crippling balance behind, know that debt settlement carries tax obligations.

The IRS views settled debt as forgiven debt. If your settled debt is more than $600, you’re liable to file Form 1099-C and pay taxes on it.

How Bankruptcy Affects Taxes

Debtors that choose to file for bankruptcy will declare either chapter 7 or chapter 13. In chapter 7 bankruptcy, a debtor’s non-exempt possessions are liquidated to help pay back the money owed. In chapter 13 bankruptcy, a court determines the level of disposable income a debtor must pay back monthly.

So, what happens if you get a tax return after declaring chapter 7 or chapter 13 bankruptcy?

In chapter 7, whether you can keep your refund depends on whether the refund is from income earned before or after the bankruptcy filing. Income received after is yours. Income before is included in the bankruptcy regardless of your filing date.

You can also sidestep this scenario before filing for bankruptcy by adjusting your withholding to reduce your refund, using the money for necessary expenses or protecting the refund with a bankruptcy exemption. Check your specific state’s exemption system for relevant protections.

In a chapter 13 scenario, the trustee assigned to your case could argue that a tax refund is a surplus and therefore disposable income that you must pay into the plan. However, it’s possible to excuse a tax refund by specifying on your return:

  • which refund needs to be excused
  • the amount of the refund
  • why the money needs to be kept

This will only work if the excuse is necessary. Things like funeral expenses, appliance repair/replacement, car repairs/down payments on a replacement vehicle, or unexpected medical costs would likely all qualify for excusing a tax refund. Just be sure to keep your documentation of expenses!

With anything as complex as taxes, ambiguities, technicalities and exceptions exist, always use online information to further your research but never let it conclusively decide it.