Tax Consequences of Debt Settlement

Debt settlement can be a big step towards a new financial beginning. Still, you must prepare yourself for the possibility that having a debt forgiven will require you to pay taxes on the amount of that debt.

Usually, the Internal Revenue Service (IRS) considers the amount of debt forgiven to be taxable income. However, there are exceptions.

Before you decide to negotiate a debt settlement, you should know if you qualify for one of those exceptions. If not, plan for how you will come up with the money to pay the tax on the settlement.

Understanding debt settlement taxes

Debt settlement is a process through which a creditor agrees to forgo payment of part of an outstanding debt. It can be the best solution to debts you are unable to pay off. However, it will affect your credit score and may result in you having to pay taxes on the amount settled.

You should understand those consequences when deciding whether debt settlement is the right solution for your situation.

What are debt settlement taxes?

Debt settlement taxes are income taxes owed on the amount of debt that a creditor agrees to forgive.

When someone forgives your debt, it's as if they gave you an amount of money equivalent to that debt. For this reason, the IRS considers the amount forgiven to be income. It must be declared on your tax return, and you will owe taxes on that amount, just as you would on any other income.

Why should you be aware of debt settlement taxes?

It's important to be aware of debt settlement taxes so you can make sure you'll have the money available to pay the taxes. Also, this expense is something you should consider when weighing the pros and cons of debt settlement.

The tax liability may also influence the timing of when you enter into a debt settlement agreement. The amount of debt involved is considered taxable for the tax year in which the creditor agrees to cancel it. You may want to manage the timing of any debt settlement agreement so that it works to your advantage.

For example, if you are negotiating a debt settlement late in the year, you may want to put off formally entering into an agreement until after January 1. That way the tax liability will be pushed off into the new year.

If you know your income will be higher next year, you may want to make your debt settlement agreement effective in a different year to lower your tax bracket.

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The impact of debt settlement on your taxes

Both the type and amount of debt you settle affect how it is treated for tax purposes.

How does debt settlement affect your tax liability?

Suppose you owe $20,000 on a credit card and are unable to pay it. You negotiate with the credit card company to reduce the amount you owe to $5,000. That means $15,000 in debt has been canceled.

Because of this, $15,000 will be added to your taxable income. Your tax on that amount will depend on the tax bracket you are in. For example, if you are in a 22% tax bracket, you will owe 22% of that $15,000 or $3,300.

What types of debt are taxable?

Most types of debt that are canceled are taxable. This can include loans or credit card debt.

The taxes apply to both the amount you borrowed plus any interest or fees that have accrued on the debt. Basically, whatever amount the creditor agrees to cancel is considered taxable income.

Are there any exceptions or exclusions?

There are several exceptions and exclusions to the taxation of canceled debt. These may apply either to the type of debt that was canceled or to your financial situation.

Here are some types of debt forgiveness that may not be taxable:

• Debt that is forgiven as part of a gift or bequest

• Student loan debt

• Debt that would have been a deductible business expense

• The amount of debt on a purchase that is canceled as part of an agreement to reduce the purchase price

• Debt that was incurred in the business of farming

• Debt that was incurred on certain real property used for business purposes

• Debt that was used to purchase or improve your principal residence.

In addition to the above exceptions, any type of debt may be excluded from your taxable income in certain situations:

• If the debt is canceled as part of a bankruptcy proceeding. This includes chapters 7, 11, or 13 bankruptcy.

• If you are insolvent at the time of the debt cancellation. This means that the amount of your total debt exceeds the market value of all your assets.

These exceptions and exclusions may be subject to very specific conditions. There is a lot at stake. If you fail to take advantage of a relevant exception or exclusion it could cost you a lot of money. On the other hand, trying to take advantage of a loophole that doesn’t apply to you could result in tax penalties. Consulting a tax advisor could help you determine the best way to approach this on your tax return.  

Reporting debt settlement on your tax return

You would report debt settlement by including the amount settled as income on your tax return. This may also require certain tax forms to document the amount.

What forms do you need to file to report debt settlement?

The entity that canceled your debt may give you a Form 1099-C. This shows the type and amount of debt that was canceled.

You may also have to fill out forms to document any exclusions from the taxable amount of your debt. These may include a form 982 for bankruptcies or worksheets that calculate insolvency, foreclosures, or repossessions.

How should you report forgiven debt on your tax return?

The amount of any debt forgiven should be reported on your tax return for the tax year in which the debt was forgiven.

Even if you don't get a 1099-C, you must include any canceled debt in your taxable income unless it's an exception.

Tips for minimizing tax liability after debt settlement

The tax implications of debt settlement are an important consideration in deciding whether settling a debt would make sense for you. You should understand what your tax liability would be and whether there are any ways of reducing that liability.

Strategies to reduce your tax burden after debt settlement

The timing of your debt settlement may affect your tax liability if your tax bracket varies from year to year. You should aim to make a debt settlement agreement effective in a tax year for which your income will be relatively low. That may put you in a lower tax bracket.

You can also avoid tax liability if you get your debts canceled as part of a bankruptcy, or if you are insolvent. Make sure to examine if the debt being forgiven fits any of the exceptions that were brought up earlier.

To prove that you were insolvent and have the debt forgiven, you can file Form 982 with the IRS. However, if your total income and assets were greater than the amount you owed when you settled your debt, you will likely end up being taxed on the debt you resolved over the past year.

Seeking professional advice for tax planning

The rules concerning the tax treatment of debt settlement are complicated, and large amounts of money may be at stake.

Unless you are confident you fully understand those rules, you may want to seek professional tax advice. You should seek this advice before you enter into a debt settlement agreement. Your tax liability may impact whether and how you pursue debt settlement.

When seeking professional advice, look for a tax expert who has specific experience with situations involving debt settlement.