How Debt Settlement Affects Taxes: What To Know Before You Settle

Debt settlement can potentially reduce the amount you owe creditors, but it might also trigger a nasty tax bill. In most cases, the IRS treats forgiven debt as taxable income, something those in financial distress often overlook. 

This doesn’t apply to every situation of forgiven debt, however.

Key Takeaways

• Forgiven debt usually counts as income. When a creditor settles a debt for less than you owe, the IRS generally treats the canceled amount as taxable ordinary income.

• Expect a Form 1099-C at $600 or more. Lenders must send Form 1099-C when they cancel $600 or more of debt, and you report the taxable amount on Schedule 1 (Form 1040), line 8c.

• No 1099-C doesn't mean no tax. You still have to report canceled debt as income even if a Form 1099-C never shows up, unless an exception or exclusion applies.

• Insolvency is the most common way to owe less. If your total debts were more than the value of everything you owned right before the settlement, you can exclude canceled debt up to the amount you were insolvent.

• Form 982 is how you claim an exclusion. To exclude canceled debt under bankruptcy, insolvency or another qualifying rule, you file Form 982 with your return and reduce certain tax attributes.

• Some canceled debt is never taxed. Debt discharged in a Title 11 bankruptcy, certain student loans and a few other categories fall under exceptions or exclusions, so the forgiven amount isn't counted as income.

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Can You Avoid Paying Taxes on Debt Settlement?

The IRS considers canceled, forgiven or discharged debt to be taxable income. But as with many IRS rules, there are some exceptions. The two that most commonly apply to people who settle consumer debt are insolvency and bankruptcy discharge. 

Insolvency means that your total debts exceed the fair market value of everything you own at the moment that your debt is canceled. As that puts you in a negative net worth situation, you theoretically have no financial gain from the transaction. This can eliminate or at least reduce the taxes you would normally owe on the forgiven amount.

Bankruptcy is another special case. One of the important provisions of the bankruptcy code is that no debts discharged in the court proceeding are considered taxable income.

Neither of these scenarios automatically applies, however, even if you technically qualify. In addition to knowing they exist in the first place, you must handle the paperwork correctly to generate your exemption. 

When Settled Debt Is Taxable and When It May Not Be

Why Forgiven Debt Can Count as Income

It might seem unfair that someone struggling with debt can get hit with a huge tax bill right when they are getting back on their feet. But taking emotion out of the equation, the financial reality makes sense.

If you borrow money, you essentially receive tax-free income. True, you usually have to pay interest on it, but from a tax standpoint, it's "free" money. If a creditor later forgives part of that balance, you've essentially kept money that you were supposed to pay back. Since that is a financial benefit, it's treated as income by the IRS.

Imagine, for example, that you owe a $15,000 credit card debt and you settle it for $5,000. The remaining $10,000, in most cases, will be taxed at your ordinary income rate. 

When Settled Debt May Be Taxable

When Forgiven Debt May Not Be Taxable

If you've gone through the debt settlement process, your most likely path to an exclusion would be insolvency, not bankruptcy.

Use this simple formula to determine if you qualify as insolvent: total debts minus total assets.

If the result is positive, it means you qualify as insolvent. However, the size of your insolvency matters, as you can only exclude canceled debt up to that figure.

If you have $50,000 in debts and $40,000 in assets, for example, you can only exclude debts up to the $10,000 difference. 

If you choose to go the bankruptcy route instead of using debt settlement, you'll be able to entirely exclude all of your debt from becoming taxable income. There are some rare exceptions, such as certain farm debt and real property business debt. You should check IRS Publication 4681 and speak with a bankruptcy attorney before you make this choice.

What Happens at Tax Time After Debt Settlement?

What Forms and Records To Expect

Creditors are required to send you Form 1099-C, Cancellation of Debt, when they forgive or cancel $600 or more. They're also required to file a copy with the IRS. You should expect to receive these forms by Jan. 31 of the year following the cancellation. 

Know How Much You Qualify for Insolvency

Neither your creditors nor the IRS are responsible for knowing that you qualify for insolvency. You'll have to make that case on your own behalf. That's why it’s important to keep accurate, detailed records of your original account balances, settlement amounts, dates of cancellation, and any other correspondence related to your debt.

If you're planning to claim insolvency, you'll also need an accurate, written record of all your assets from the day before your debt was canceled.  

What To Do Before You File

1. Collect all of your 1099-C forms and verify their accuracy. If you spot an error, contact your creditor before you file.

2. Determine whether you qualify for an exclusion. Use the IRS Publication 4681 insolvency worksheet to complete the calculation accurately.

3. If you determine that an exclusion applies, file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your return. Without this form, the IRS won't have a way of knowing if you qualify.

4. Remember to include the total amount of forgiven debt on your federal income tax return, even if you claim an exclusion. The IRS needs you to report this figure if you want to exempt it. 

5. Verify if your state conforms to federal exclusion rules. 

Common Mistakes To Avoid

• Ignoring a 1099-C because you think the debt is "old" or already resolved

• Failing to report canceled debt even if you didn't receive a 1099-C. Just because you didn't receive a Form 1099-C doesn't mean that your canceled debt isn't taxable. You're still legally responsible for reporting the transaction.

• Assuming you're not eligible for the insolvency exclusion. Even if your insolvency doesn’t cover the full amount of your canceled debt, you can still benefit from even a partial exemption. 

• Skipping Form 982. Even if you qualify for an exclusion, you have to file this form. The exclusion is not automatic.

Is Debt Settlement Still Worth It if Taxes Are Involved?

When Settlement May Still Make Sense

• If you're in a better financial position after paying taxes on the forgiven amount than if you had simply kept the debt in the first place 

• If you won't owe any additional taxes on the forgiven amount because you qualify for the insolvency exclusion 

• If you've already defaulted and your account is in collections.

• If the total amount forgiven is relatively modest and your tax hit will be manageable.

When Debt Settlement May Not Be the Best Fit

• If you can set up a debt management plan with an affordable monthly payment and can avoid the tax complication of canceled or forgiven debt.

• If you have consistent and sufficient income to keep making at least the minimum monthly payments on your outstanding debt.

• If you're in a scenario where bankruptcy can offer more immediate legal protection, such as if you're being sued or having your wages garnished.

• If your debts won't qualify for settlement, such as most tax and student loan debt.

Final Take

Debt settlement can seem like a great way to get out of debt, but it doesn't come without consequences. In addition to the damage to your credit report, you may face both settlement fees and tax consequences. Analyze the full picture, including all of your total costs and the ramifications of your choice, before you decide how to proceed. 

FAQs

Do you have to report settled debt if you never receive a 1099-C? 

Yes. The IRS requires you to report canceled debt on your tax return for the year it was forgiven. This is true whether or not you ever receive a Form 1099-C from your creditors. 

Can you owe taxes if only part of a debt was forgiven? 

Taxes apply to the portion of your debt that was forgiven, whether or not it represents the entire amount of your original balance. So, if you settle a $10,000 debt for $3,000, the $7,000 that was forgiven will be considered taxable income unless an exclusion applies.

Should you talk to a tax professional before agreeing to a debt settlement?

Since you can usually get a free consultation, it's worth it to speak to at least one professional, especially if your debt is significant. A good tax professional can help you identify which might be the best course of action for you and whether you might qualify for insolvency or bankruptcy. 

Is forgiven credit card debt taxed differently from other settled debt? 

The IRS applies the same canceled debt income rules to credit cards, personal loans, and most other unsecured debts. This is the type of standard consumer debt that most people settle. However, if you have some type of exclusion per IRS rules, it could be treated differently than credit card debt. 

Key Terms

• Canceled debt: A debt that's forgiven or discharged for less than the full amount owed, which the IRS generally treats as income.

• Cancellation of debt (COD) income: The forgiven balance that's added to your taxable ordinary income unless an exception or exclusion applies.

• Form 1099-C: The IRS form a lender files and sends you when it cancels $600 or more of debt, showing the canceled amount and date.

• Insolvency: Being insolvent means your total liabilities were more than the fair market value of your assets immediately before the debt was canceled; you can exclude canceled debt up to that amount.

• Form 982: The form you attach to your return to exclude qualifying canceled debt from income and reduce your tax attributes.

• Exceptions: Categories such as gifts, certain student loans and deductible debt that keep canceled debt out of income without reducing tax attributes.

• Exclusions — Qualifying situations: Title 11 bankruptcy, insolvency, qualified farm debt, qualified real property business debt and qualified principal residence debt — that let you leave canceled debt out of income.

• Tax attributes: Credits, losses, carryovers and the cost basis of your assets. When you exclude canceled debt from your income, you have to trim these back — though never below zero.

Sources

• IRS Topic No. 431, Canceled Debt – Is It Taxable or Not? Overview of when canceled debt is taxable and how to report it.

• IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments: Detailed rules, exceptions, exclusions and the Insolvency Worksheet.

• IRS About Form 982: How to exclude discharged debt and reduce tax attributes.

• Taxpayer Advocate Service: Cancellation of Debt: Taxpayer-focused guidance on canceled-debt situations.

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