How Your Debt Settlement Can Result in Higher Taxes

When you can't figure out how to pay off debt, one option to help you reduce what you owe and get a new financial start is debt settlement. Debt settlement occurs when a creditor agrees to accept less than your owed balance. Once you’ve completed the process, you might breathe a sigh of relief.

However, you might not be done paying. After you’ve settled your debt, the IRS might come knocking on your door. Here’s what you need to know about the debt settlement taxes you could be responsible for.

How does a debt settlement affect your taxes?

“The IRS considers forgiven or canceled debt as income if you settle for at least $600 less than the original balance,” says Leslie Tayne, a lawyer specializing in consumer debt. “The creditor is required by law to file the cancellation of debt notice with the IRS.”

As far as the IRS is concerned, the money you borrowed (but didn’t repay) is income. That means you have to pay taxes on it.

To the IRS, this makes sense, according to Tayne, because in many cases you have likely benefited from the amount borrowed. For instance, say your debt originated by buying items with a credit card. Now that some or all of your debt is canceled, you still have the benefit of the funds — that is, the things you bought with your credit card — without having actually repaid what you borrowed.

If you settle debt during the year, you should receive a 1099-C tax form from the lender detailing the specifics of the debt that was canceled.

When you get this form, you’ll file it along with your tax return. If the debt was personal, you’ll list the income amount from your 1099-C on line 21 of the Schedule 1 form and then attach it to your 1040 form.

Realize, too, that if you enter a debt settlement program, you might end up with a 1099-C for several years in a row. Debts can be settled at a varying pace, so one creditor might be satisfied one year and another creditor might end up agreeing to a settlement in a later year.

Once the forgiven debt is listed on your tax return, it will be lumped in with the rest of your income, and you’ll pay debt settlement taxes as part of your regular tax bill.

What settled debts are (and are not) considered taxable?

Almost any type of debt forgiveness is taxable. Whether you receive student loan forgiveness after being on an income-driven repayment plan or you receive forgiveness for credit card debt, there’s a good chance the amount forgiven will be considered taxable income.

If you have property that’s repossessed, it’s usually treated as though you sold it to the creditor. The amount of forgiven debt that’s considered income will depend on whether you signed a note claiming personal liability for the property. In these cases, it’s important to consult with a professional to figure out what type of debt you have and to help you accurately calculate the formula for what’s considered taxable.

Exceptions and exclusions to debt settlement taxes

There are some instances when you won’t have to pay taxes on forgiven debt. Here are some of the circumstances in which you could get a break from the IRS:

• The canceled debt is part of an inheritance, bequest, or gift.
• Your student loans are forgiven through the Public Service Loan Forgiveness (PSLF) program or a health services program for underserved areas.
• Your debt is canceled due to a Title 11 bankruptcy case.
• You have qualified farm indebtedness.

Additionally, Tayne points out, if you can prove that you were insolvent at the time you settled your debt, you might be able to avoid paying taxes on the amount.

“Basically, if the amount of debt you owed is more than the total of your income and wealth, you’re insolvent,” says Tayne.

4 things to do if you think you’ll be taxed on settled debt

As you prepare to settle your debt, consider the potential tax consequences. If you think you might end up paying debt settlement taxes or if you already received a 1099-C form, here are four things you can do to prepare yourself.

1. Consult a tax expert

One of the best things you can do when you’re concerned about the tax implications of debt settlement is to speak with an expert. Sit down with a tax professional to verify which debt forgiveness amounts are actually taxable and which debts you might not need to worry about.

2. Keep good records

If you want to prove that you shouldn’t have to pay debt settlement taxes, make sure you have good records. Whether you want to prove you were insolvent at the time of the settlement or you want to verify some other information, clear records are essential to argue your case.

For instance, some business and farm debt won’t result in taxes, so make sure that such items are properly documented.

3. Save up money to pay your bill

Hopefully, now that you’ve settled your debt, you have some extra cash flow and the ability to save. Do your best to set aside money regularly from the time of your settlement until tax day so you have the funds to pay the IRS when your tax bill is due. This may mean you need to explore how to make extra cash.

4. Consider an IRS payment plan

For those who qualify, the IRS offers payment plan options if you can’t pay your taxes by April 15. You can set up a plan based on how much you owe and make monthly payments. This is an alternative to not paying your taxes and running the risk of having tax debt on top of everything else.

Note that the IRS does charge additional fees for payment plans.

Bottom line

If you’ve decided that debt settlement is the best way for you to move forward with your finances and get out of debt, make sure you’re aware of the tax consequences involved. While there are some exceptions, most people should prepare to pay debt settlement taxes.