The Tax Consequences of Debt Settlement

You finally did it! You made it through a debt settlement program, all your debts were successfully negotiated, and financial freedom has arrived. You are officially debt-free! It’s time to sit back, relax, and breathe a sigh of relief…

Well, not quite yet. 

What many people don’t realize is that, once your debt is settled with your creditors, your debt-free journey isn’t over just yet. According to the Internal Revenue Service (IRS), you’re going to need to pay taxes on the amount settled. If this revelation leaves you confused, stunned, or scared, don’t fret! We are here to answer your most pressing questions. Read on to learn more about the tax consequences of debt settlement.

Can the IRS Really Tax Me on My Settled Debt?

The short answer is yes; the IRS can tax you on debt that you’ve settled. The long answer is a bit more complicated. When you take out a loan or make a charge to your credit card, you don’t have to pay taxes on the money you receive because there is the understanding that you will pay the full amount back. If you have that debt settled, you aren’t responsible for paying back the full amount anymore. In the eyes of the IRS, the difference between the original balance and how much you settled for is considered taxable.

According to the Internal Revenue Code §61 (a) (12), any debt forgiveness or “cancellation of debt” (COD) that occurs when a creditor reduces the amount owed is considered taxable income. Your lender then reports the amount you didn’t pay to the IRS as lost income. Examples of COD that are characterized as taxable income includes debts such as:

  • Credit card debt settlements
  • Settlements of $600 or more
  • Pay-offs negotiated with collections agencies 
  • A short sale on a physical property

Are There Any Exceptions?

If you know anything about taxes, then you know there are exemptions which allow you to deduct money from your taxable income—all laid out in complicated legalese! In more easily understandable language, here are six of the most common exemptions to taxation on forgiven debt:

  1. School loans that have been forgiven due to the borrower pursuing an occupation in the “public interest,” such as nursing or teaching in underserved areas
  2. Certain types of farm loans
  3. Loans taken out in your name without your knowledge (e.g., identity theft)
  4. Debts discharged during the bankruptcy process
  5. Loans taken out with the purpose of purchasing, building, or repairing the borrower’s primary residence
  6. Cases of insolvency 

A full list of exemptions can be found in IRS Publication 4681.

The Insolvency Exemption

The last exemption is particularly relevant to those pursuing or completing a debt relief program. Many individuals who decide that debt settlement is right for them do so because they owe more money than they could reasonably pay back. If this is the case, then the borrower is considered insolvent. Suppose a taxpayer is insolvent immediately before their debt is settled. In that case, the IRS allows them to exempt the COD income that results from the settlement. 

When you plan to claim insolvency, it is essential to account for the forgiven amount on Form 982. This form helps the IRS determine the amount of indebtedness that can be taken out of your gross income. 

How Much Will I Have to Pay?

What you pay to the IRS in taxes is based on how much your initial debt was and how much it was settled for. Depending on the type of debt you had, your lender should send you what’s known as a 1099-C Cancellation of Debt tax notice form. This form shows you the amount of debt canceled and the date of cancellation. The lender will also send a copy of this form to the IRS, alerting them to the terms of the debt cancellation. As we mentioned previously, you’ll be taxed on the remainder of the debt, or what you didn’t pay. You’re required to report this amount under “other income” on your yearly tax return.

Even if you don’t receive a 1099-C from a lender, you are still legally required to report the canceled or settled debt as income. This income will be taxed at your average income tax rate. 

Is Debt Settlement Still Worth It?

In a majority of cases, debt settlement is still the best path to debt relief! The taxes you’ll pay will likely be significantly less than paying off the debt in full. Debt relief programs also help you get out of debt faster, meaning you’ll probably have the funds you need to pay taxes on your COD income. 

Still unsure about the decision to settle your debt? Request a Custom Debt Plan. No upfront costs, no obligations, and most importantly, no surprise taxation to explore your options! Reach out to one of our debt specialists today!

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