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 will, 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. They are always eager to report this lost income to the IRS to lighten their tax burden.
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. The end of the tax year is the deadline for sending in these forms.
What You Need to Know about Form 1099-C
According to the IRS, 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 owe money on an identifiable event as reported to the IRS.
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 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.
- Student loan forgiveness on account of fulfilling a work requirement, death, or student loan repayment assistance.
- Your debt would have represented a deductible expense.
- Some investor incentive payments, such as Principal Reduction Alternative payments and Pay-for-Performance Success 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, if its amount is more than the canceled debt. If it is less, you can only exclude the amount equal to the insolvency amount. You must report the remaining amount of canceled debt as income.
- If you are insolvent (i.e., your total liabilities exceed your total assets) at the time the debt is forgiven, you may be able to exclude the forgiven amount from your taxable income up to the extent of your insolvency. You will need to file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to claim this exclusion.
- Qualified real property business indebtedness, qualified principal residence indebtedness, and qualified farm indebtedness can also exclude your forgiven debt from your income.
How Much Do You Have to Pay?
The normal tax rate in the US is 10-37 percent, depending on your taxable income. A high income lands you in a higher tax bracket. Correspondingly, a lower income lands you in a lower tax bracket.
How to Minimize Tax Consequences
Nobody likes to pay extra money to the IRS and there are legal ways to minimize the tax consequences of debt settlement. You need strategic planning and a good overview of the options and exemptions available to you.
Insolvency Exclusion
If you were insolvent when your debt was forgiven, you may not have to pay taxes on debt forgiven. Insolvency occurs when your total liabilities exceed your total assets. To claim this exclusion, you need to file IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and provide a detailed calculation of your assets and liabilities at the time the debt was settled.
Bankruptcy Discharge
If your debts were discharged in bankruptcy, the forgiven debt is typically not considered taxable income. Both Chapter 7 and Chapter 13 bankruptcies allow for this exclusion. You must file Form 982 along with your tax return to claim this benefit.
Qualified Principal Residence Indebtedness
There have been provisions that exclude forgiven debt on a principal residence, often related to mortgage restructuring or foreclosure. While these provisions have been temporary, it's a good idea to check the current IRS guidelines to see if this exclusion is available for the tax year in question.
Qualified Farm and Real Property Business Indebtedness
Special rules apply for debts related to farming or business real estate. If you qualify under these categories, you can exclude forgiven debt from your taxable income. Check the IRS guidelines or consult a tax professional who can help you understand if you meet the criteria.
Tax Professional Consultation
Hire a tax professional or financial advisor. They can provide personalized advice, help you understand tax laws, and find all possible exclusions and deductions. Their expertise can maximize your potential tax savings and avoid costly mistakes.
Accurate Record-Keeping
Keep records of your financial situation, including all communications and agreements with creditors. Accurate documentation can support your claims for insolvency or other exclusions.
What if I Don't Report Settled Debt on My Taxes?
It’s never a good idea to try to avoid paying taxes. Here is a list of reasons why you should report canceled debt.
IRS Penalties and Interest
If you don’t report debt forgiveness, the IRS may assess penalties and interest on the unpaid taxes. This can increase your tax liability. Penalties for underreporting additional income can be substantial, and the interest on unpaid taxes accrues daily until the debt is paid.
Audit Risk
Creditors report forgiven debts over $600 to the IRS using Form 1099-C. If the information on your federal tax return doesn’t match the records the IRS receives, it can trigger an audit. It’s a sign to the IRS that you are not an honest citizen and you should be audited.
Collection Actions
The IRS has extensive powers to collect unpaid taxes. If you fail to report the amount of forgiven debt and pay the associated taxes, the IRS can take collection actions against you. This may include wage garnishments, levies on your bank accounts, and liens on your property.
Damage to Credit Score
IRS collection actions and tax liens may adversely affect your credit score and make it harder to obtain loans, credit cards, or even secure housing and employment.
Legal Consequences
Willfully evading taxes is a federal offense that can result in fines and imprisonment. While such extreme measures are typically reserved for egregious cases, they underscore the importance of compliance with tax laws.
Amended Tax Returns
If you realize you failed to report forgiven debt after filing your tax return, you can file an amended return using Form 1040-X, Amended U.S. Individual Income Tax Return.
Correct your mistake to mitigate some penalties and show the IRS your intention to comply with tax laws.
Debt Settlement and Tax Consequences
The legal framework can be complicated and doesn’t really lend itself to easy interpretation. Only a tax legal professional can offer proper recommendations regarding how debt settlement may impact your tax obligations and advice concerning the tax you may owe on your forgiven debt.
Though there may be some tax implications of settling your debt, these are typically minor when weighed against the savings most people achieve with debt settlement. To find out how much you might be able to save, contact a ClearOne Certified Debt Specialist at 866-481-1597 today to discuss your situation, explore your best debt relief options, and get a free savings estimate.
