When people use a credit card, they are borrowing money from the card issuer. If repaying the loan becomes a financial burden, they can take steps to reduce or even eliminate the debt. However, these steps, from ignoring the loan to making payment arrangements with the lender to loan forgiveness, may have credit score and tax consequences that borrowers should understand before making that first move.
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Ignoring the Debt
While some consumers choose to ignore the debt, this rarely makes the obligation disappear. States have statutes of limitation that define the length of time a creditor can sue a debtor for repayment of credit card debt. Banks and other credit issuing institutions often sell uncollectible debt to collection agencies, which then contact the debtor with attempts to collect the money. While the Fair Debt Collection Practices Act of 1977 prevents debt collectors from harassing the debtor with excessive telephone calls, calling in the middle of the night or threatening the debtor, these phone calls typically do not stop until some resolution is made on the debt.
IRS Form 1099-C
Sometimes it is possible to call the credit card company and arrange to settle the debt for a reduced payment. If the company agrees, it may be possible, for example, to pay off a $5,000 debt for $3,500. The credit card account is then closed and no more calls are received by the creditor trying to get payment. However, this debt forgiveness may be a taxable event. The bank may send the consumer and the Internal Revenue Service a Form 1099-C for the amount of money forgiven. That money -- in this example $1,500 -- is considered ordinary income by the IRS and is taxable.
Debt forgiveness is not a taxable event with bankruptcy. When a person declares bankruptcy, he is claiming to be financially insolvent, with debt far exceeding his assets. A bankruptcy court judge evaluates the debtor's financial situation and can eliminate the debt, reduce the debt or arrange a payment plan.
The debtor can contact the credit card company and ask for help with payments. An example of this "workout plan" is the debtor agreeing to pay more than the monthly payment for a fixed period while the creditor agrees to lower the interest rate or even eliminate interest during that time, allowing more of the payment to go toward debt owed versus interest and penalties.
Any type of debt forgiveness will have a negative effect on the debtor's credit score. Bankruptcy itself can drop an excellent credit score of around 800 to a low of 650. However, late payment or nonpayment of debt may result in a continuing lower score, while arranging debt forgiveness presents the opportunity to rebuild a better credit score.