Settling a debt for less than you owe can save you thousands of dollars. But many people are surprised to learn that the IRS may treat the forgiven portion as income. Here is what you need to know so tax season does not catch you off guard.
Why Forgiven Debt Can Count as Income
If you owe $10,000 and your creditor accepts $4,000 as payment in full, $6,000 of debt has been canceled. In general, the IRS considers canceled debt to be taxable income, because you received money or credit that you no longer have to repay.
What Is Form 1099-C?
When a creditor cancels $600 or more of debt, it is generally required to send you and the IRS a Form 1099-C, Cancellation of Debt. The form shows the amount canceled and the date. You may receive one for each settled account, usually early in the year after the settlement.
Even if you do not receive a form, canceled debt may still need to be reported. Keep copies of every settlement letter so you have accurate records.
The Insolvency Exclusion
You may not owe tax on canceled debt if you were insolvent right before the debt was canceled. You are insolvent when your total debts are greater than the fair market value of everything you own.
For example, if your debts totaled $40,000 and your assets were worth $30,000, you were insolvent by $10,000. You could exclude up to $10,000 of canceled debt from your income. To claim the exclusion, you generally file IRS Form 982 with your tax return.
Many people who seek debt settlement are insolvent, but you need to do the calculation using your own numbers.
Other Exceptions
Debt discharged in bankruptcy is not taxable, and certain other types of canceled debt have their own rules. The IRS explains these in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.
How to Prepare
- Save every settlement agreement and payment confirmation.
- List your assets and debts as of each settlement date in case you need to show insolvency.
- Set aside money for possible taxes if you do not expect to qualify for an exclusion.
- Talk with a qualified tax professional before you file.
This article is for general information only and is not tax advice. Tax rules can change, so consult a tax professional about your situation.
Plan With the Full Picture
A good debt relief plan accounts for taxes, fees and your timeline from the start. Learn more about how debt settlement works, or request a free consultation with Alliance Settlement.
