Before Settling Your Debts, Understand the Tax Consequences
March 13, 2023
Are you in debt and considering settling your credit card debt? While debt settlement may seem like an attractive option to reduce your debt balance, it’s essential to understand the potential tax implications that come with it.
Before settling your debts, you must know whether the forgiven amount will be treated as income and subject to taxes. It would help if you also understood the circumstances under which you may not need to pay taxes on the forgiven amount.
Understanding the tax implications is crucial to avoid any unpleasant surprises come tax time, whether you’ve already settled your credit card debt or are considering doing so.
Settling a Debt May Increase Your Taxable Income
Though debt settlement can reduce the amount you have to pay creditors, it could leave you with an unexpected tax bill.
When you settle a credit card debt, the lender or debt buyer may be required to file Form 1099-C, Cancellation of Debt, if they canceled $600 or more of the debt you owe. In addition, the IRS considers the forgiven amount as income, which means you may need to pay taxes on it. That additional income might also push you into a higher tax bracket, resulting in a larger tax bill.
Insolvency Avoids Taxes on Cancelled Debt
One major exception to the taxation of canceled debt arises when dealing with insolvency.
Insolvency refers to a situation where your total liabilities exceed the fair market value of your assets. In other words, you are insolvent when you owe more than you own. This definition is relevant when determining whether you qualify for the insolvency exclusion from taxable income resulting from canceled debts.
The IRS provides guidelines for calculating insolvency, which involves adding up all your debts and determining the fair market value of all your assets. If the total of your debts exceeds your assets’ value, then you are insolvent. The insolvency calculation includes assets and liabilities excluded from the canceled debt amount.
If you prove that you were insolvent when the debt was canceled, you may be able to exclude some or all of the canceled debt from your taxable income. This exclusion is claimed on IRS Form 982, which is used to report the canceled debt you are excluding from your income.
Bankruptcy as a Tax-Free Alternative to Debt Settlement
If you’re struggling with multiple debts, consider bankruptcy as an alternative to debt settlement.
When juggling many obligations, there’s a risk that not all of your accounts will settle, and you’ll have to deal with ongoing collection efforts such as lawsuits and judgments. Even if you resolve all your debts, the resulting tax liability and increased balance due to continuing interest and collection fees may negate much of the cost savings you achieved.
In contrast, bankruptcy resolves all debts quickly and efficiently. This allows you to start rebuilding your credit sooner than if you had pursued debt settlement. Plus, unlike debt settlement, debts discharged in bankruptcy do not cause a tax liability.
Over the past 27 years, many of my clients have found that filing for bankruptcy was a faster, easier, and less expensive way to resolve their debts and rebuild their credit.
The Value of a Tax Professional in Navigating Debt Settlement
When it comes to taxes, things can get complicated quickly. Work with a licensed tax professional instead of an online service to ensure you make the best financial decisions.
An experienced, licensed tax professional can help you navigate the nuances of the tax code and ensure you’re taking advantage of every available exemption and deduction. Completing tax forms incorrectly or misinterpreting the tax code can lead to penalties and additional fees. A tax professional can help you avoid these pitfalls and ensure you take the proper steps to minimize your tax liability.
Remember that all tax preparers have different levels of expertise and qualifications. Some claim they “do taxes” but lack formal training or certifications. Others treat tax preparation as a side hustle but don’t have the qualifications to guide you appropriately. Do your independent research and find someone who can provide you with the guidance you need.
The Right Advice Matters
For some people, debt settlement can be a great way to deal with overwhelming debt. However, before taking action, talk with an experienced bankruptcy lawyer like me to see if there’s a better way to deal with your financial problems. If you decide that settlement is the best route, be aware of the tax implications and consult a licensed tax professional.
ABOUT THE AUTHOR
Since I became a lawyer in 1995, I’ve represented people with problems involving student loans, consumer debts, mortgage foreclosures, collection abuse, and credit reports. Instead of gatekeeping my knowledge, I make as much of it available at no cost as possible on this site and my other social channels. I wrote every word on this site.
I’ve helped thousands of federal and private student loan borrowers lower their payments, negotiate settlements, get out of default and qualify for loan forgiveness programs. My practice includes defending student loan lawsuits filed by companies such as Navient and National Collegiate Student Loan Trust. In addition, I’ve represented thousands of individuals and families in Chapter 7 and Chapter 13 bankruptcy cases. I currently focus my law practice solely on student loan issues.
I played a central role in developing the Student Loan Law Workshop, where I helped to train over 350 lawyers on how to help people with student loan problems. I’ve spoken at events held by the National Association of Consumer Bankruptcy Attorneys, National Association of Consumer Advocates, and bar associations around the country. National news outlets regularly look to me for my insights on student loans and consumer debt issues.
I’m licensed to practice law in New York and California and advise federal student loan borrowers nationwide.