Debt settlement saves you money by shaving off a set amount of your loan principal. You will, however, owe taxes on the money you save this way. In many cases, it qualifies as income, and you need to report it as such to the IRS.
There are some legal intricacies involving income resulting from debt settlement. Tax law is complicated, and we are not making any tax recommendations here. Contact an accounting professional or tax attorney for details about your debt settlement savings and their tax implications.
Topics covered here include:
- How debt settlement works and why it generates “income”
- Form 1099-C – the way to report canceled debts to the IRS
- Exceptions and exclusions
- How much tax you may have to pay on your forgiven debt
Why Debt Settlement Creates Income
One of the main selling points of debt settlement is that it saves you money. Unlike debt counseling, debt settlement aims to provide debt resolution through the forgiveness of some of your debt. This way, you end up paying back less, and your remaining debt costs less in interest.
Your creditors 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, your canceled debts do not fall off the radar. Instead of being the income of your creditors, 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. 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.
The IRS makes it clear that even if you do not receive such a form, you must report forgiven debt as gross income.
The amount of forgiven debt on the form may or may not include interest and fees. If it does include them, you have to report them as income as well, unless the interest would be deductible if you paid it.
Be aware that you owe tax on debt forgiven 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 Cancelled 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.
- Part of your student loan debt is forgiven 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 your forgiven debt 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.
- 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.
Tax Law Is Complex
The legal framework is not easy to navigate, and it does not lend itself to easy interpretation. Only a tax legal professional can offer you legal recommendations regarding tax impacts and advice concerning the tax you may owe on your forgiven debt.
Though there may be some tax implications resulting from debt settlement, they are typically minor when weighed against the savings most people are able to achieve with debt settlement. To find out how much you might be able to save, contact a ClearOne Certified Debt Specialist today at 866-481-1597 and get a free savings estimate.
