Debt settlement saves you money by shaving off a set amount of your credit card principal. It’s a viable solution when you feel that the debt amount on credit cards you have accumulated is simply unmanageable on your current income.
You may, however, owe taxes on the money you save this way. In many cases, it is considered income, and you are required to report it as such to the Internal Revenue Service (IRS). For example, if you owe $25,000 in debt and your creditors agree to settle personal loans for $15,000, you will be taxed on the remaining $10,000.
There are some legal intricacies involving income taxes resulting from debt settlement. Before reading on, please keep in mind that tax law is complicated, and we are not making any tax recommendations here. Contact an accounting professional or tax attorney for details about tax implications of debt settlement savings.
Can Debt Settlement Work for Me?
One of the main selling points of debt settlement over other debt relief methods, such as a debt consolidation loan, is that it saves you money. Unlike debt counseling, debt settlement aims to provide resolution through forgiveness of some of your debt. This way, you end up paying back less, and your remaining debt costs less in interest.
Your creditor may agree to forgive some of your debts, in exchange for having you pay back the rest. The problem is that the money they forgive represents lost income for them. Creditors may be required to report canceled debt to the IRS on form 1099-C.
From the perspective of the IRS, debt cancellation does not fall off the radar. Instead of being your creditor’s income, it becomes your income instead. The way the IRS sees it, the party liable for paying taxes on this income is you.
For any forgiven debt exceeding $600 of the principal, your creditor is legally obligated to send you and the IRS a Form 1099-C, Cancellation of Debt.
Visit the IRS website to see the latest guidelines on when form 1099-C is due to the IRS.
What You Need to Know about Form 1099-C
According to the IRS, Form 1099-C reports an identifiable event involving canceled debt. If you receive a Form 1099-C from an applicable entity like a credit union, a bank, a federal government agency, or any organization that lends out money as a significant part of its business, you may owe taxes. Receiving the form does not automatically mean the amount is taxable, but it must be reviewed and reported appropriately.
Even if you do not receive such a form, you must report forgiven debt as gross income. Specifically, creditors are required to report a canceled debt of $600 or more to the IRS. You will receive a copy of Form 1099-C, which details the amount of debt forgiven and needs to be included in your tax filings. Check that the information on the form is accurate as any discrepancies can lead to further complications with the IRS.
The canceled debt amount on the form may or may not include interest and fees. If it does include them, you may have to report them as ordinary income as well, unless the interest would be deductible if you paid it.
Be aware that you also owe taxes on settled debt as the result of foreclosure when the lender sells the property for less than the owed amount and forgives the difference.
You May Not Always Have to Pay Tax on Your Canceled Debt
Some exceptions and exclusions may disqualify your forgiven debts as income. In such cases, you may not have to pay tax on them. A tax attorney can help you determine if any of these exclusions apply to your particular situation.
- Your canceled debt takes the shape of a gift, inheritance, or bequest.
- Certain student loan forgiveness
- Your debt would have represented a deductible expense.
- Some investor incentive payments are non-taxable forgiven debt.
You can apply exclusions to your forgiven debt after the mentioned exceptions. Such exclusions can also eliminate loans forgiven from your income.
- Debt forgiven as a result of Chapter 7, 11, or 13 bankruptcy is non-taxable.
- Insolvency rules may allow partial or full exclusion.
- You may need to file Form 982 to claim exclusions.
- Certain real estate and farm debts may qualify for exclusion.
How Much Do You Have to Pay?
The normal tax rate in the US is 10–37 percent, depending on your taxable income. A higher income places you in a higher tax bracket, while a lower income places you in a lower bracket.
How to Minimize Tax Consequences
There are legal ways to minimize the tax consequences of debt settlement through proper planning and understanding available exclusions.
Insolvency Exclusion
If you were insolvent when your debt was forgiven, you may not have to pay taxes on it. You must file IRS Form 982 and provide supporting calculations.
Bankruptcy Discharge
Debt discharged in bankruptcy is typically not considered taxable income. Form 982 must be filed to claim this.
Qualified Principal Residence Indebtedness
Certain provisions may exclude forgiven mortgage debt. Check current IRS guidelines.
Qualified Farm and Real Property Business Indebtedness
Special rules may allow exclusion of certain business-related debts.
Tax Professional Consultation
A tax professional can help identify exclusions and ensure compliance.
Accurate Record-Keeping
Maintain detailed financial records to support any claims.
What if I Don't Report Settled Debt on My Taxes?
Failing to report forgiven debt can lead to serious consequences.
IRS Penalties and Interest
You may face penalties and interest on unpaid taxes.
Audit Risk
Mismatches with IRS records can trigger an audit.
Collection Actions
The IRS may pursue wage garnishment, levies, or liens.
Future Financing Risk
Tax liens can complicate future financing.
Legal Consequences
Tax evasion can result in fines or imprisonment.
Amended Tax Returns
You can file Form 1040-X to correct errors and reduce penalties.
Debt Settlement and Tax Consequences
Tax laws can be complicated. Consult a qualified professional for guidance.
Though there may be tax implications, they are often minor compared to the savings from debt settlement. Contact a ClearOne Certified Debt Specialist at 866-481-1597 to explore your best debt relief options and get a free savings estimate.
