A successful debt settlement is not always the end of the road for borrowers. The IRS considers forgiven debt as taxable income. Find out if you qualify for an exclusion.
You stuck with your debt settlement like a trooper for two years. Making those monthly payments required more ramen noodle dinners than you care to remember, but you finally received the final debt settlement letter from your creditors, and that made it all worthwhile. You are now debt-free. Or are you?
Sadly, many debtors close one door on debt collectors only to open another door to the biggest debt collector of them all. The taxman.
How the IRS converts debt into income
It may sound like a sick joke or the best accounting trick ever, but the IRS considers forgiven debt – which is what a debt settlement is – as taxable income.
Here is how it works. When lenders accept a debt settlement, they typically report the difference as lost income to the IRS, which helps reduce their tax burden. Of course, the IRS still wants to collect the tax on this money and expects you to foot the bill.
Let’s say you owed $20,000, and your credit card company accepted a $10,000 settlement, you may be liable for the taxes on $10,000. Depending on your tax bracket, your tax liability could be anything from $1,000 to $3,960. A $1,000 tax bill is preferable to a $10,000 debt, but it can be quite a shock if you don’t know it’s coming.
Exceptions to the debt settlement as income rule
The good news is there are several circumstances when the IRS cannot peg a tax bill on your forgiven debt. The bad news is that most of those exceptions don’t apply to unsecured debt. Here are the cliff notes on forgiven debt exclusions. Stay with me to the end. I saved the one that is most likely to apply to debt settlements for last.
- You discharged the debt in bankruptcy.
- Your student loans were canceled as part of an agreement to work in a certain profession or for a particular employer.
- You’re a farmer. Farmers have several avenues to claim a break on the forgiven debt.
- The canceled debt was on your main residence.
- The forgiven debt is a gift. Needless to say, this is unusual, because creditors can’t claim a tax break on gifts.
- The debt was a business expense that would have been tax-deductible. Just don’t forget you can’t claim the same business expense as a tax deduction.
- You were insolvent when your creditor agreed to the debt settlement. This is a loophole that applies to many borrowers who complete a debt settlement program, particularly just before the settlement is accepted.
So what does it mean to be insolvent?
Sadly, a lot of people don’t take advantage of this exception because they misunderstand the meaning of insolvent. If you have paid taxes on forgiven debt, you may be eligible for a tax refund without even knowing about it. According to the Taxpayer Advocate Service, a significant percentage of taxpayers who qualify for exclusions, particularly the insolvency exclusion, do not make claims. Insolvency is a legal term that requires you to owe more than the value of your assets. You don’t have to look or feel dirt poor to be insolvent.
To find out whether you are insolvent, add up your assets just before the debt settlement. Then deduct your debts, including the debt forgiven in the settlement. If your debts are worth more than your assets, you’re insolvent and don’t have to pay taxes on your canceled debt. Notice that even if your debt settlement pushes you out of insolvency you still can claim a deduction on part of your “taxable income.” Here are a couple of scenarios to illustrate it.
John owes $50,000 and his assets are worth $40,000. His creditors agree to forgive $9,000 as part of a settlement. He is still $1,000 in the red, so he doesn’t have to pay taxes on the forgiven debt.
Jane, on the other hand, owes $50,000 and her assets are worth $40,000. Her creditors forgive $15,000 as part of a debt settlement. She has to report $5,000 (not $15,000) in income on her next tax return.
What is a 1099-C Form?
Most people first hear about paying taxes on canceled debt when they receive a 1099-C form in the mail. A 1099-C is a tax notice that reports a canceled debt. Pay attention to boxes 2 and 6 of the form. Box 2 gives you the amount of debt you were forgiven, and box 6 specifies how the debt was canceled.
Here is a cheat sheet for the codes the IRS uses to describe the “identifiable event” that causes debt cancellation.
- A: Bankruptcy
- B: Other types of judicial debt relief
- C: Statute of limitations (time to collect debt ran out)
- D: Foreclosure
- E: Debt relief from probate
- F: By agreement. This is the code you will see if your debt was canceled as part of a debt settlement
- G: Creditor’s decision or policy to stop collections
- H: Expiration of nonpayment testing period
- I: Intermediate debt cancellation before one of the events described above
How do you report income from a debt settlement?
Your first step should be to make sure you don’t qualify for an exception. Another reason to work with a debt settlement company that employs tax attorneys and CPAs.
If you qualify for an exclusion, you don’t need to report your canceled debt on your tax return. However, you may have to file a Form 982 if the exception was related to insolvency or bankruptcy.
If you don’t qualify for an exclusion, you need to report the canceled debt on the “other income” line of your tax return or on your Schedule C if the debt was related to your business.
Consider spending a few extra dollars on a premium tax preparation package after a debt settlement. Tax preparation programs like TurboTax and TaxAct can walk you through the “income” reporting process.
Completing a debt settlement program may come with a tax bill hidden inside. The IRS considers canceled debt as income but you qualify for a tax break if you were insolvent when you accepted the debt settlement. Talk to a tax attorney or, even better, hire a debt settlement company that has tax attorneys and CPAs on its staff.
Andrew is the managing editor for SuperMoney and a certified personal finance counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.