Debt Settlement And Income Taxes


If you have worked out a deal with a creditor to settle your debt are you aware that there may be tax implications? Many creditors during debt settlement negotiations fail to let consumers know that once their debt is settled, they could be hit with a hefty tax bill. Here is what you need to know if you already have or plan to settle your debt.

Debt Settlement Is Considered Income

The IRS considers any debt that you have settled over the amount of $600.00 as taxable income. Therefore, if you settle $10,000.00 worth of debt for the cost of $5,000.00, the amount of debt that was forgiven ($5,000.00) is considered taxable income for the tax year in which the debt was settled. After the debt has been settled, your creditors are responsible for reporting the forgiven amount as income to the IRS and must issue you a 1099-C form. The 1099-C is a cancellation of debt IRS form that must be filed with your yearend federal tax return.

Are There Any Circumstances Where You Won’t Owe Tax Dollars On Settled Debt?

Under certain circumstances you may be entitled to an exemption or a reduction in taxable income incurred from a debt settlement. If you receive a 1099-S form due to a debt settlement you will want to take immediate action, work with a tax specialist who understands the laws and find out what exemptions or reductions you might qualify for.

An exemption or reduction may be granted in the case of debts forgiven during a bankruptcy and for debts forgiven to an individual who is insolvent, meaning they have liabilities above and beyond their assets. Additionally, the IRS currently has a special program in place to help homeowners who were foreclosed on as a result of the housing market crisis. For tax years 2007 to 2012 these homeowners may qualify for an exemption or a reduced tax liability.

In order to qualify for a reduction or an exemption, tax payers must file IRS form 982 along with their 1099-C form when they file their federal tax return.

What Else You Need To Know About Debt Settlement And Tax Liability

Many people are unaware that when they settled their debt there would be tax implications. Whether you knew ahead of time or not, if you do not qualify for a tax exemption you will need to pay taxes on the amount of debt you had cancelled.

If you are considering a debt settlement and are uncertain whether or not you should enter a debt settlement agreement because of possible tax liabilities, you may want to speak with a tax specialist or a debt settlement expert who is familiar with how the process works. In most cases you are still probably better off settling your debt.

Comments

  1. There definitely could be tax implications, and a lot of companies fail to disclose this. I think one important piece that you forgot to mention is the “insolvency” issue. If you owe more than what you are worth, you don’t have to be liable for taxes.

    See: IRS PUBLICATION 4681

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Debt Settlement and Income Taxes 2

Learn about Form 982, 1099-C, The Truth about Reporting Forgiven or Cancelled Debt as Income, and How You May Be Able to Avoid Paying Anything By Declaring Yourself Insolvent.

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*Disclaimer: I am not a tax professional, nor do I claim to be one. Any information on this website is based on my experience and is for informational purposes only and should not be acted upon solely on it’s merit. It’s recommended that you seek the help of a qualified professional to prepare your taxes.

Debt Settlement – A Quick Overview

With the tougher new bankruptcy laws, debt settlement is a much more palatable solution for a great majority of consumers. In review, debt settlement is an agreement between a consumer and a creditor to settle an outstanding balance for a significantly lower amount than what is owed. This amount is frequently less than 50% of the original debt with the remainder being forgiven. So you end up saving a bunch of money and your debt is gone forever.

Cancelled Debt is Considered Taxable Income

What isn’t commonly known is that creditors are required to report forgiven debts greater than $600 to the IRS on form 1099. This notifies the IRS that you have settled your debt for less than full balance. Here’s the thing: the IRS views this cancelled debt as taxable income and wants you to pay taxes on it.

Don’t freak out and stop your debt settlement proceedings just yet, though.

The truth is that most of those who choose a debt settlement solution are NOT liable for taxes on the forgiven debt. The IRS gives an out for debtors who are “insolvent” at the time of debt settlement.

The term “insolvent” simply means that your debts exceed the value of your assets. If you are in a situation where a debt settlement is necessary, you are probably insolvent. In other words, you would have a negative net worth where your liabilities outweigh your assets.

So How Do I figure Out If I Am Insolvent?

At the end of the year, you’ll get a 1099-C from the creditor with which you settled. The 1099-C will usually have a DATE that your debt was cancelled, and it should match your records about the time you sent them the settlement check.

The cancellation date is important because that’s the point of reference to determine your solvency. List all your assets and liabilities(debts) as they stood on that date. Use market value of your house and cars to determine their value as an asset.

I used www.zillow.com for my house’s market value (comparable sales) and www.kbb.com for the car’s value (private party sale). If you’re preparing your taxes well after the cancellation date, you can approximate their value for the cancellation date.

If your debts exceed your assets for that date in time, and the amount you are insolvent to exceeds the cancelled debt amount, then you can declare yourself “insolvent” for that settlement. (See Example Below) If you settled more than 1 debt, you must repeat this process for each cancelled debt.

IRS Form 982 and What to Attach to Your 1040

To let the IRS know about your insolvency, you must fill out IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness. (pdf)

To make sure I filled out the form right, I called the IRS (you should too) to ask. They were very helpful and instructed me that for settlement of credit card debt, check box 1b, fill out line 2 and line 10a with my total cancelled debt for the year. Thats it for form 982. Be sure to attach it to your tax return with the documentation in the next section.

How to Document your Insolvency to the IRS

If you determined that you were insolvent on your debt cancellation date, then you need to attach some documentation. According to the IRS phone support rep, a simple spreadsheet showing your assets and liabilities like this will suffice:

You should do this for each cancelled debt for which a settlement occured in the given tax year.

What if I’m NOT Insolvent?

In the case that you DO end up owing taxes on the forgiven debt, simply report it (the amount shown on the 1099-C) as income on Line 21 (Other Income) on your 1040 Form.

Keep in mind that the amount you settled on added to the taxes you will owe is STILL much less than what you would have paid to the creditor in the long run. Especially if you had gone on paying minimum payments! Chances are that the interest alone on the payments you would have made far exceed the amount of taxes assessed.

Either way, you save money, eliminate your debt and get to sleep at night. You still won by settling your debt.

Seek a Qualified Professional

We strongly suggest that you seek the advice of a tax specialist to ensure your insolvency. This will ensure that you are doing things properly and correctly and that you won’t have to worry about the IRS coming back in 5 years on a clerical error or something. In matter like these, it’s ALWAYS a good idea to seek the advice of a professional.

The final word is that you probably will not end up owing a tax liability on forgiven debt. It is just a good idea to get checked out before you get caught in a situation you didn’t expect. The advice is to be prepared.

Comments

  1. Has anyone been able to use Turbo Tax when you need to complete Form 982?

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