Tax Consequences of Debt Settlement

Debt relief can be a big step towards a new financial beginning. Still, you must prepare yourself for the possible tax consequences if you choose to settle debt. The Internal Revenue Service (IRS) usually considers forgiven debt to be taxable income, but there are some exceptions.

Before you decide to negotiate a debt settlement, find out if you qualify for one of those exceptions. If you don’t, it’s a good idea to factor the tax cost into your overall debt strategy. 

How Debt Settlement Taxes Work

When you settle a debt, the creditor or debt collector agrees to accept a smaller amount than what you owe. Debt settlement is sometimes the best solution for debts that you’re unable to pay off. 

For tax purposes, canceled debt is taxable income unless you qualify for tax-free debt forgiveness.

You should understand the tax consequences of debt settlement to decide if it’s 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.

Here’s an example.

• Amount of debt: $15,000

• Creditor agrees to accept: $8,000

• Creditor agrees to forgive: $7,000

• Amount added to your taxable income for the year: $7,000

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

Why should you be aware of debt settlement taxes?

When you know that debt settlement taxes exist, you can be more prepared to pay the taxes. Also, this expense is something you should consider when weighing the pros and cons of debt settlement.

The tax liability could 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’re negotiating a debt settlement late in the year, you may want to put off formally entering into an agreement until after Jan. 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 before the end of the year. You’ll then be able to claim the forgiven debt income for the current year while you’re in a lower tax bracket.

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Can You Avoid Taxes on a Debt Settlement?

There are several exceptions and exclusions to the taxation of canceled debt.

You might not have to pay taxes on a debt settlement, depending on the type of debt and your financial situation. 

Any type of debt may be excluded from your taxable income in the following situations:

• The debt is canceled as part of bankruptcy. This includes Chapter 7, Chapter 11, and Chapter 13 bankruptcy. People who complete the bankruptcy process are already required to pay as much as they can to their creditors. The IRS doesn’t tack on additional costs in the form of taxes.

• You’re 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. You need to show that you’re insolvent by submitting Form 982 with your tax return.

Concerned about being unable to pay your tax bill? If you’re insolvent, you won’t owe income taxes on forgiven debt. The IRS has an insolvency determination worksheet you can use to check. You should consult with a tax professional to figure out if you’ll qualify for tax-free debt forgiveness.

There are certain types of debt forgiveness that may not be taxable, regardless of whether you’re insolvent:

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

• Student loan debt (depending on when it was forgiven)

• 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

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?

Debt settlement normally increases your taxable income, meaning you need to pay more in taxes.

Here’s a quick example of how this can work:

• You owe $25,000 on a credit card that you can’t pay in full.

• You negotiate with the credit card company or work with a professional debt settlement company, and you make a deal to settle the debt for $10,000. 

• That means $15,000 in debt has been canceled and must be added to your taxable income.

• Your tax on that amount will depend on the tax bracket you’re in. If you’re in a 22% tax bracket, you could owe $3,300 in taxes on the canceled debt.

What types of debt are taxable?

Most types of debt that are canceled are taxable. This can include:

• Credit card debt

• Personal loans

• Private student loans

• Medical debt

• Payday loans

• Unsecured business 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.

Reporting a 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?

You may receive a Form 1099-C from the entity that canceled your debt. Creditors and debt collectors are required to send this tax form for debt settlements of $600 or more. The form 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.

We’re not tax professionals and we can’t advise you on your specific situation. 

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 run the numbers on what your tax liability would be and research whether there are any ways of reducing that liability.

Strategies to reduce your tax burden after debt settlement

The timing of your debt settlement could affect your tax liability if your tax bracket varies from year to year. In this case, aim to make a debt settlement agreement effective in a tax year for which your income will be relatively low. If you settle your debt during a year when you’re in a lower tax bracket, you’ll pay less in taxes on the forgiven debt.

You can also avoid tax liability if you get your debts canceled as part of a bankruptcy, or if you're insolvent. Also, make sure to examine if the debt being forgiven fits any of the exceptions mentioned above.

If you’re claiming insolvency, you need to prove you were insolvent by filing Form 982 with the IRS. If your total income and assets were greater than the amount you owed when you settled your debt, then the IRS likely won’t consider you insolvent, and you’ll end up being taxed on the debt you resolved over the past year.

Seek 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’re confident you fully understand these 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.

Should You Choose Debt Settlement?

Debt settlement is often the most effective way to get rid of debt so you can move forward to a better financial future. If you have too much debt to pay back, then you might be a good candidate for debt settlement.

You should consider the tax consequences of debt settlement, too. If you’re in a situation where your debts outweigh your assets, then you might meet the requirements for insolvency.

It could be a different story if you’re interested in debt settlement because you have assets you don’t want to lose in bankruptcy. If your assets are larger than your debts, you could face a tax bill for any debt you have forgiven. You’d need to decide if hanging on to your assets while settling your debt is worth paying additional taxes.

While there are pitfalls in debt settlement, it could give you a clear path out of a tough situation. If you’d like help with your debt, learn about how Freedom Debt Relief works and the way our trained experts can help you negotiate a reasonable settlement.