Debt Settlement Tax Concerns

When consumers borrow money and fail to repay their debt for a period of time, the collections process begins. Debt collectors who contact consumers about repayment may be willing to work out a deal—the consumer can pay off the debt for less than the original amount in one, lump-sum payment. Debt settlement is beneficial for both parties: the consumer, who saves money by paying less than originally owed, and the creditor, who receives some money and avoids writing off the entire balance as a loss. 

One caveat that isn’t always considered by the consumer is that the amount of unpaid debt is generally reported to the IRS as income. This means the consumer may need to pay taxes on the difference between the debt that was originally owed and what was actually paid.

How debt settlement taxes work

An Internal Revenue Service (IRS) regulation requires that consumers who receive a benefit of more than $600 from settling a debt must pay taxes on that amount. For example, someone with a $3,000 debt who settles it for $2,000 has a savings of $1,000 and needs to pay taxes on that amount. Typically, the lender that forgave the debt will send both the consumer and the IRS a 1099-C “Cancellation of Debt” Form in January for this purpose.

The tax amount that must be paid is based on the consumer’s current tax rate, which is based on taxable income. Since the United States has a progressive tax system, taxes increase along with a consumer’s income. For most types of income, there are seven tax brackets: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent. a consumer falls into a 22% tax bracket and saved $1,000 in a debt settlement, for example, they could end up having $220 added to their tax bill in the upcoming year. Larger settlement savings would result in a larger amount of taxes that need to be paid.

If a 1099-C Form is not received in the mail, the lender may have still submitted one to the IRS. If the income is not listed on a consumer’s tax return but the IRS has the information, it could result in a tax bill or an audit. To avoid paying even more fees in IRS interest and penalties, it is always best to report income honestly and completely. 

Is debt settlement worth it?

An exception to this rule of income reporting could occur if a consumer is insolvent. Insolvency happens when the value of debts outweighs the value of assets—or essentially, you owe more than you own. A simple way to determine if you are insolvent is to make two lists: one for all the things you own (your assets), and one for everything you owe (your debts). 

When listing your assets, include things like a vehicle you own outright, your 401(k) and/or IRA account, equity in your home, etc. When considering your debts, be sure to list all credit card balances, student loans, your mortgage, medical debt, and any other borrowed money. Total the amount of money on both lists to see which is larger. If the debts outweigh the assets and you are insolvent, then IRS Form 982 “Reduction of Tax Attributes Due to Discharge of Indebtedness” can be included with your tax return as an exclusion. It is always a good idea to review taxes with a certified tax professional, but this basic system can help determine whether to expect taxes to be owed on debt settlement.

Even if taxes are owed on debt settlement savings, consumers are generally still better off than paying their original debt balance in full—particularly if they didn’t have funds available to pay it in the first place. Since debt forgiveness doesn’t appear on a credit report in detail, it can also help repair the appearance of creditworthiness. Rather than showing up as “paid in full”, the debt will appear as “settled” instead. This can help a credit score over time, since the debt is cleared and no longer considered delinquent.  

The bottom line for debt settlement is that it always pays to be prepared. By being aware of tax implications and performing some quick calculations, you can set yourself up for greater financial success by planning for the upcoming tax season. If you think you may need to pay taxes on a debt settlement, you can include it in your budget and start saving ahead of time.

If you need assistance connecting with your financial institutions, Kredit can help.