Taxes and Debt Settlement: What to Know

If you are overwhelmed by debt, debt settlement is a great way to take charge. Debt settlement allows you to resolve your debt quickly and for less than owed. If you have chosen debt settlement this blog can help you prepare for the upcoming tax season.

📝 Not Familiar with Debt Settlement? Here is a Quick Recap:
Debt settlement is an agreement between the borrower and creditor that allows the borrower to resolve their debt for a reduced amount. The creditor gets the advantage of getting paid for the debt without having to write it off, and the borrower gets out of debt faster and for less money.

Do I pay taxes on debt settlement?

Sometimes but it depends on the amount of debt settled. The IRS requires creditors to send you a 1099-C cancellation of debt tax notice if the difference between the debt settlement paid and the original debt owed is greater than $600.

When you receive the 1099-C notice, you should report the amount as “other income” on your tax return. 

What happens if I don’t receive a 1099-C from my creditor?

If your creditor forgets to send you a 1099-C form that means the IRS is not aware of the canceled debt. However, that doesn’t mean you aren’t responsible for taxes on canceled debt income!

If you are chosen for an audit, it is possible the IRS will uncover the canceled debt. 

If you don’t receive a 1099-C form from a creditor consult your tax advisor for more information on how to proceed. 

The Tax Implications of Canceled Debt

For tax purposes, “canceled debt” refers to the difference between your original debt and the amount you paid the creditor when the debt was resolved. This amount is what you saved on your settlement and the IRS calls it “canceled debt” and considers it a form of income if it is over $600. Settlement fees don’t count toward your canceled debt balance. 

There are many different types of canceled debt, settlements with a financial institution are just one type. Other types include bankruptcy, charge-offs, stockholder debt and personal debts.

When canceled debt is added to your income, you will be taxed for it in the income tax bracket for which you qualify. In 2021, tax rates will range from 10% to 37%.

There are a variety of exceptions and exemptions that may or may not apply to debt settlement.

Amounts that meet the requirements for any of the following exceptions and exclusions aren’t included in income, even though they’re cancellation of debt income:

1. Amounts canceled as gifts, bequests, devises, or inheritances
2. Certain qualified student loans canceled under the loan provisions that the loans would be canceled if you work for a certain period of time in certain professions for a broad class of employers
3. Certain other education loan repayment or loan forgiveness programs to help provide health services in certain areas.
4. Amounts of canceled debt that would be deductible if you, as a cash basis taxpayer, paid it
5. A qualified purchase price reduction given by the seller of property to the buyer
6. Amounts from student loans discharged on the account of death or total and permanent disability of the student.
7. Debt canceled in a Title 11 bankruptcy case
8. Debt canceled to the extent insolvent
9. Cancellation of qualified farm indebtedness
10. Cancellation of qualified real property business indebtedness
11. Cancellation of qualified principal residence indebtedness that is discharged subject to an arrangement that is entered into and evidenced in writing before January 1, 2021

Source IRS.gov

Insolvency and Debt Settlement Taxes

The canceled debt exception most likely to apply to debt settlement is insolvency. 

What is insolvency?

Insolvency occurs when your total debt exceeds your total assets. If you are insolvent, your canceled debt will be excluded from income taxation up to the amount you were insolvent.

Should I worry about debt settlement taxes?

It’s necessary to understand how canceled debt is taxed and not to ignore it when you file your taxes. However, paying taxes on settled debt should not be feared. 

If your boss offered you a raise, would you reject it because you have to pay taxes on that money? Probably not! 

Getting out of debt is liberating and will have long-term benefits to your financial health. Saving money through debt settlement is a responsible way to take charge of your finances, paying taxes is equally responsible. 

Paying taxes on settled debt may be inconvenient, but can be a normal part of the debt settlement journey and means you are well on your way to a debt-free life.

Please Note: This blog shouldn’t substitute professional advice from an accountant. We aren’t qualified to make decisions about your taxes; only you can do that. The information in this blog can help you stay informed as you consider your options based on your specific circumstances.