Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Debt Discharge

What it is:

A debt discharge is a legal action that relieves a borrower from his or her obligations to a lender.
 

How it works (Example):

Debt discharge typically happens during bankruptcy, which is a legal process under which a borrower protects and or liquidates assets in order to repay debts.

In general, there are three “types” of bankruptcy, each named after a section of U.S. bankruptcy law. In most cases, a debtor files a petition with the local bankruptcy court. In general, under Chapter 11 bankruptcy, which is for businesses, a judge decides whether to discharge an individual's debt. The judge can deny the discharge if the debtor failed to keep adequate records, failed to explain the loss of any assets, committed a crime, disobeyed court orders, or did not seek credit counseling.

Under Chapter 7, which is for individuals, partnerships or corporations that have been unsuccessful with a Chapter 11 filing, a judge also decides whether to discharge debt. Like Chapter 11 filings, the judge can deny the discharge if the debtor failed to keep adequate records, failed to adequately explain the loss of any assets, committed a crime, disobeyed court orders or did not seek credit counseling.

The law works to prevent people from filing Chapter 7 merely to get a debt discharged and avoid repaying a debt. This is why not all individuals qualify for Chapter 7, especially those with high monthly incomes or those primarily saddled with consumer debts (i.e., credit card debt). If the individual does not qualify for Chapter 7, the case usually becomes a Chapter 13 case, where the individual must still repay the debt, albeit under a payment plan.

In Chapter 13, also called a wage-earner's plan, individuals can restructure their finances in order to repay their debts. A person can emerge from Chapter 13 (that is, be "discharged") if all of the debt is repaid and she has completed a financial management course.

Once a debt is discharged, the debtor's creditors can no longer pursue the debtor for payments or try to collect the discharged obligations. However, a judge can revoke a discharge if the court finds that the borrower lied or submitted fraudulent information during the bankruptcy proceedings.

Many kinds of debt cannot be discharged, no matter what. These include (but are not limited to) student loans, tax liabilities, homeowners association dues, child support, alimony and personal injury judgments.

Why it Matters:

Debt discharges via bankruptcy is usually a last resort for individuals and businesses. A discharge virtually ruins a person’s credit for several years, making it very difficult and expensive to borrow money in the future.

Additionally, and perhaps more important, that discharged debt can become taxable income on which the borrower will owe taxes to the IRS. For example, if you borrow $1,000 from a bank and then get the debt discharged, this is essentially the same as getting to keep the $1,000, which makes it taxable income. For this reason, the lender will often send a Form 1099-C to the borrower and the IRS after discharging the debt.

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