Many people think that “bankruptcy” is a dirty word. Somehow even though the Bankruptcy Code allows individuals a fresh start if you have fallen on financial hard times, it does not feel right to some people. Instead, the debt settlement option seems more attractive.

It isn’t and here is why.

There are tax consequences when you settle debt. You do not want to exchange unsecured debt or under secured mortgage debt for tax debt. The simple reason is that you cannot discharge tax debt in bankruptcy if circumstances lead you to file later, and the I.R.S. has much broader collection remedies than credit card creditors.

Here is the tax issue in a nutshell, with two examples.

Discharge of debt is included in the definition of income under the Tax Code. Therefore, any amount of credit card debt that you “settle” and avoid paying is added to your income in the year that the debt is settled. The credit card company will send you a copy of a Form 1099 with information that they have reported to the I.R.S. Your tax liability will depend on your other income, but you will likely have an increased liability.

A “short sale” is a sale of real estate that does not pay off the mortgage. The mortgage lender has to agree to the terms of the sale. If you short sell your primary residence there is currently an exemption from tax for any amount of the mortgage you do not pay but this exemption is limited in amount and it expires on December 31, 2012. It looks like politics may affect its extension. The tax exemption does not apply to investment properties that are subject to a short sale, only your primary residence. You can read our blog on the tax exemption issue here.

In addition, you may experience collection attempts on settled debt. Credit card companies sell delinquent debts. Sometimes a debt may be sold more than once. If you settle with a creditor or a debt collector, the debt may still turn up in a pool of debts acquired by a debt buyer. This will result in additional attempts to collect a debt that you have already settled. This subsequent collection activity is wrongful and you should contact experienced counsel if you find yourself in this situation. If you live in Massachusetts or Connecticut, we can help resolve wrongful collection claims. Use the contact page on our website to get assistance.

None of the issues discussed in this article occur in a bankruptcy case. A bankruptcy discharge does not result in liability for discharge of debt. It may also be possible to avoid and not pay second mortgages that are completely unsecured due to reduced real estate values and sustain no tax liability. Lien avoidance is a complex subject. You can read my discussion of lien avoidance on my National Bankruptcy Forum blog.

Bankruptcy may be a better solution to your financial problems. You need experienced counsel to review your options. Contact us to discuss your specific concerns in Massachusetts or Connecticut.