Like most people, when I drive to work in Irvine every morning I surf the various local radio stations. I’ve noticed a lot more advertisers for debt reduction plans, sometimes called debt elimination or debt negotiation, lately. The fact that they advertise on the radio tells me that the current financial stress is impacting everyone – whether living in Rancho Santa Margarita, Santa Ana or Newport Beach.

But debt reduction plans are not always as helpful as they might sound. Why? Debt forgiveness doesn’t eliminate as much debt as you might think. The reason: Borrowers must often pay high fees and pay income tax on the forgiveness of debt.

You see, debt forgiveness is usually considered to be a taxable event, because a taxpayer is deemed to have gained something (income) by not having to pay back the debt. So, our U.S. and California tax laws impose a tax on forgiveness of debt “income.”

The taxes are often waived if the forgiveness of debt occurs while the borrower is insolvent or bankrupt (filing a bankruptcy is not required), so it doesn’t always impact every debtor, but here’s an example of how it might affect a typical borrower:

Net Benefit of Debt Reduction Plan

1. $100,000 Total Debt
2. $40,000 Reduced Debt (expected payoff)
3. $15,000 Debt Reduction Fees (attorney/debt consultant fees)
4. $16,200 Forgiveness of Indebtedness Tax (see below)
5. $71,200 Total Payments After Debt Reduction
6. $28,800 Net Benefit After Debt Reduction

Forgiveness of Indebtedness Tax Calculation

1. $45,000 Taxable Forgiveness of Indebtedness (forgiveness of debt less fees)
2. $12,600 Federal Tax for Forgiveness of Indebtedness (assumes 28% tax bracket)
3. $3,600 State Tax for Forgiveness of Indebtedness (assumes CA 8% tax bracket)

In this greatly simplified example, a borrower paying a 15% fee on a $100,000 debt reduction plan and who must pay typical income tax rates on the anticipated 60% forgiveness of indebtedness “income” would only benefit by approximately $28,800. Although it is a benefit, it’s far less than the “60%” reduction amount that most people expect when they hear a radio add promising a reduction of “up to 60%.”

Something to think about before deciding to sign up for a debt reduction plan…