San Diego Debt Relief: Settlement and Consolidation
| Preparing a Budget |
FIRST STEP MIGHT INVOLVE: BUDGETING TO PAY OFF DEBT
How to calculate your debt-to-income ratio:
The first step is to calculate your monthly take home pay. If you’re paid every other week, multiply your take home pay by 26 and divide by 12. This is your monthly take home pay. The second step is add up your total monthly debt payments. Add the current minimum payments for all credit cards and loans, except for mortgage or rent. Now, divide your total monthly debt payment by your monthly take home income. This is your debt to income ratio. You should be okay if your debt-to-income ratio is less than 20%. Typically a debt ratio higher than 20% is problematic.
PREPARING A BUDGET
Preparing a budget means tracking your personal cash flow, how much money is coming in and how much is going out. Collect your bills, credit card statements and bank statements, receipts for items you buy with cash. If you haven’t been keeping records of your spending, you may have to keep track of the money you spend before you can create an accurate budget. Programs like Quickens or Microsoft Money can help you track expenses.
Divide your spending into fixed and variable categories. Fixed costs are typically mortgage payments, rent or loan payments. Variable costs are things like clothing, food, entertainment. Reducing fixed expenses (refinancing, moving to cheaper apartment) although possible is typically harder to do then reducing variable expenses. Decide what you can cut and then cut it.
The United States Department of Justice publishes some National Standards for living expenses. Compare your spending against the national and local averages:
Food/Housekeeping Supplies/Apparel & Services/Personal Care Products & Services/Miscellaneous
Out of Pocket Healthcare Costs
California Local Housing and Utilities Standards
Budgeting is a habit that gets easier when you see positive results. It is a good idea to track the savings each month. Set goals like paying off debts and saving money. Setting goals helps motivate you in cutting back spending. This is why some recommend paying off the smaller accounts regardless of interest rates. This is risky of course because it’s typically the larger accounts that come calling with lawsuits. Settling the small accounts but having to file Bankruptcy anyway because ultimately you can’t get affordable terms from one or more large creditors leads to unfavorable results.
A great website for calculating what it will take to pay off credit cards is Bankrate.com.
Some people swear by software packages like Quickbooks™ or Quicken™ to keep track of income and expenses. Others find these softwares too cumbersome but opt out for some online apps or create their own worksheets. It’s like dieting or exercise, the best approach is whichever one you will stick with and keep using it.
RELIEF THROUGH DEBT SETTLEMENT
Debt settlement involves negotiating with creditors for a smaller sum than what is owed. Debt Settlement is an option when there is access to lump sum of cash or other financing. Common problem among people struggling with debt is that cash or source of financing is one thing that is lacking.
Some people choose to take money out of or borrow against their retirement savings. Such option should be carefully considered. Depleting assets reserved for your retirement, could have catastrophic consequences in the future. The worst scenario is when debtors settle some debt by using retirement funds but end up filing for bankruptcy later anyway on the rest of the debt.
Forgiven debt is considered income. Creditor is likely to send a 1099 form at the end of the year for the difference between what was owed and what was paid. Consult a tax specialist to determine income tax implications. There are taxation exceptions for certain types of debts as well as insolvent debtors to the extent of insolvency. Learn exactly where you stand before settling accounts so that you not only understand the full cost of settlement and are prepared for tax consequences. Exchanging unsecured debt like credit cards and medical bills with priority debt, such as income taxes, is not advisable. From the Bankruptcy perspective, unsecured debt is dischargeable while priority debt is not dischargeable except under particular circumstances.
Buyer Beware: Private for-profit debt settlement firms advertise very attractive claims.
First, you may want to consider someone local. If something goes wrong, you know where to go.
Second, always read the contract. Read the fine print BEFORE you commit. If you have been sued there may be a sense of urgency to get signed up on a payment plan with a settlement company to make the lawsuit stop. Note that partically problematic are programs where a debtor makes monthly payments toward building an escrow, which is supposed to be used in the future for settlement purposes.
Typically, a percentage of the monthly payments are eaten up by fees collected by the company. If 40 percent of what is paid is taken as fees, depending on how much is owed, the account may need to grow over a significant amount of time to make settlement feasible since the fees greatly stifle that growth and the debt continues to grow with interest and further impacting credit scores as the accounts become more delinquent. Meanwhile, creditor’s collection efforts continue. If in the end what is settled is little more than accumulated interest, the benefit of settlement becomes less clear, particularly if income tax will be due on the forgiven portion.
A great link discussing Settling Credit Card Debt can be found here: Federal Trade Commission Consumer Protection website.
Stay clear of debt relief companies that:
- charge any fees before it settles your debts
- guarantee they can remove your unsecured debt
- tout a “new government program” to bail out personal credit card debt
- promise that unsecured debts can be paid off with pennies on the dollar
- tell you to stop making payments to or communicating with your creditors
- tell you it can stop all debt collection calls and lawsuits
- claim that creditors never sue consumers for non-payment of unsecured debt
- promise that using their system will have no negative impact on your credit report
- claim that they can remove accurate negative information from your credit report.
NACBA CONSUMER ALERT!!!!!: Debt Settlement NACBA Consumer Alert: Debt Settlement
RELIEF THROUGH DEBT CONSOLIDATION
A number of non-profit agencies offer this service conveniently online. Some large ones worth mentioning are www.Incharge.org and www.moneymanagement.org. These companies are funded in part by public agencies and corporate sponsors, which by the way includes the creditors. The U.S Trustee office, component of the Department of Justice, lists Trustee approved credit counseling agencies in every state.
Debt consolidation combines all credit card debt into one monthly payment. This option may be right for people who cannot do a lump settlement but can afford to make payments over time. The credit counseling agency reviews your income, assets, and expenses, and assists your with creating a budget. They work with the creditors to reduce interest, finance charges, and extend repayment time. Debtors considering bankruptcy can benefit by going through the debt consolidation process if for nothing more than to get a handle on their budget and learn whether this option is affordable.
Debt Consolidation Considerations & Caveats
Is the budget realistic? Does it create great risks by excluding expenses for important needs like: health or disability insurance? Does the plan mean you must rob Peter to pay Paul by deferring payment of income taxes, child support, or borrowing more from other sources? Is the repayment plan realistic as far as how long it will take to pay debts in full?
If your repayment plan will take 7 to 10 years to complete, under Bankruptcy you might use that same amount of time to start saving and working towards restoring your credit. Are there future anticipated decreases in income or increases in expenses (for example, if the mortgage is on variable interest, do you know when it is due to adjust and if this will increase your payment and by how much) that will make it impossible to actually complete the plan? Setting unrealistic budget will lead to failing out of the plan and a loss of time and valuable assets.
Tax Consequences When Creditor Writes Off or Settles a Debt
The IRS may count a debt written off or settled by your creditor as taxable income to you. If you settle a debt with a creditor for less than the full amount, or a creditor writes off a debt you owe, you may owe money to the IRS. The IRS treats the forgiven debt as income, on which you may owe income taxes.
Why the IRS Can Assess Taxes on Forgiven Debts
Here’s how it works. Creditors often write off debts after a set period of time — for example, one, two, or three years after you default. The creditor stops its collection efforts, declares the debt uncollectible, and reports it to the IRS as lost income to reduce its tax burden. The same is true when you negotiate a debt reduction. The creditor will report the amount you didn’t pay as lost income to the IRS. Of course, the IRS still wants to collect tax on this money, and it will turn to you for payment. Because you no longer have to pay the full amount of the debt, the IRS treats the forgiven amount as gained income, for which you should pay income taxes.
Foreclosures and property repossessions
This rule applies even to debts you owe after a house foreclosure or property repossession. In this situation, the law can seem especially cruel: Not only have you lost your property, but you’ll also have to pay income tax on the difference between what you originally owed the lender and what it was able to sell your property for (called the “deficiency”). However, the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) changed this for certain loans during the 2007, 2008, and 2009 tax years only. (The Law has been extended to cover mortgages through 2012) The law provides tax relief if your deficiency stems from the sale of your primary residence (the home that you live in). Here are the rules:
- Loans for your primary residence. If the loan was secured by your primary residence and was used to buy or improve that house, you may generally exclude up to $2 million in forgiven debt. This means you don’t have to pay tax on the deficiency.
- Loans on other real estate. If you default on a mortgage that’s secured by property that isn’t your primary residence (for example, a loan on your vacation home), you’ll owe tax on any deficiency.
- Loans secured by but not used to improve primary residence. If you take out a loan, secured by your primary residence, but use it to take a vacation or send your child to college, you will owe tax on any deficiency.
Even if you don’t qualify for an exception under the Mortgage Forgiveness Debt Relief Act, you might still qualify for tax relief. If you can prove you were legally insolvent, you won’t be liable for paying tax on the deficiency. See “Exceptions on Reporting Income,” below, for details on the insolvency exception.
IRS Reporting
Any financial institution that forgives or writes off $600 or more of a debt’s principal must send you and the IRS a Form 1099-C at the end of the tax year. These forms are for reporting income, which means that when you file your tax return for the tax year during which a debt was settled or written off, the IRS will make sure that you report the amount on the Form 1099-C as income. Even if you don’t get a Form 1099-C from a creditor, the creditor may very well have submitted one to the IRS. If you haven’t listed the income on your tax return and the creditor has provided the information to the IRS, you could get a tax bill or an audit notice. This could end up costing you more in IRS interest and penalties in the long run.
Exceptions to Reporting Income
There are several reporting exceptions stated in the Internal Revenue Code. For example, if the financial institution issues a Form 1099-C, you do not have to report the income on your tax return if:
- the cancellation or write off of the debt is intended as a gift (this would be unusual)
- you discharge the debt in Chapter 11 bankruptcy, or
- you were insolvent before the creditor agreed to settle or write off the debt.
Insolvency means that your debts exceed the value of your assets. To figure out whether or not you were insolvent, you will have to total up your assets and your debts, including the debt that was settled or written off.
- Example 1: Your assets are worth $35,000 and your debts total $45,000, so you are insolvent to the tune of $10,000. You settle a debt with a creditor who agrees to forgive $8,500. You do not have to report any of that money as income on your tax return.
- Example 2: Your assets are worth $35,000 and your debts still total $45,000, but the creditor writes off a $14,000 debt. You don’t have to report $10,000 of the income, but you will have to report $4,000 on your tax return.
If you conclude that your debts exceed the value of your assets, include IRS Form 982 with your tax return. You can download the form off the IRS’s website at www.irs.gov. If you are suffering from debt troubles, get help from Solve Your Money Troubles: Get Debt Collectors Off Your Back & Regain Financial Freedom by Robin Leonard (Nolo).