How Does Debt Settlement Affect Taxes

Posted on January 3, 2022 in Debt

If you’ve been struggling to pay a debt and were offered a debt settlement, you may feel a little relief knowing you have an option to settle. While you may settle the debt you owe with the creditor, you’ve created another debt by settling. When you agree to a debt settlement with your creditor, it’s likely the IRS will expect you to pay up, so you’ll want to know how debt settlement affects taxes and what the consequences may be.

Recent data from The Urban Institute shows that one in three Americans have delinquent debt. Medical bills (16%) make up the highest amount of debt, with student loans, automobile loans and credit card debt coming in close behind.

With so much debt on the rise, debt settlement is becoming an excellent option for people to achieve debt relief and begin building wealth again. Debt settlement can be a good thing. In that, it gives people a chance to put some debt behind them. But debt settlement may come with a higher price tag than just the lump sum payment. Learn how taxes on settled debt may affect you with our in depth guide below.

What is Debt Settlement?

Debt settlement is an agreement between you and a creditor to settle a debt you owe. With debt settlement, both parties agree on a reduced amount for what you owe, and that amount has to be paid in full. That is a win-win for the borrower and the creditor because the borrower no longer owes the creditor anything after making the lump sum payment. And the creditor considers the debt settled and won’t have to write off the entire balance.

But consumers should know that anyone considering debt settlement should also factor potential tax consequences and obligations into their budget. Creditors have a legal obligation to report forgiven debt to the IRS. When this happens, the IRS sees your forgiven debt as taxable. Since you’ve borrowed money that you aren’t paying back, you essentially have money left in your pocket. The implications of debt settlement come with the price of paying additional taxes.

Learn how taxes can be affected by settled debt, and how you will have to pay based on your income and forgiven debt.

What Are The Implications of Debt Settlement?

Debt settlement sounds good at first glance, but what the creditor may not tell you is how settling your debt could affect your taxes and your credit report. Read on to better understand the tax consequences and implications of settling your debt.

How Debt Settlement Affects Taxes

Consumers benefit from having their debt essentially wiped away by a debt settlement. However, when you have a significant portion of debt forgiven, the IRS treats the unpaid portion like taxable income and collects taxes on the difference between what was owed and what was actually paid. In most instances, when you have $600 or more in debt that has been forgiven, and you no longer have to pay, your creditor will notify the IRS by sending them a Form 1099-C. You may also receive a 1099-C from the lender once the debt has been settled. But even if you don’t receive the form, you still have to report your forgiven debt as income. The IRS will match what your creditor reports as a forgiven debt against your tax return, so if you don’t report it they will send you a notice.

How Much Taxes To Pay on Forgiven Debt

If you’re wondering whether or not you owe tax on a forgiven debt, the answer is yes. You have to pay taxes on forgiven debt, also known as canceled debt. Forgiven debt is the difference between what was owed on a debt and what you actually paid to settle that debt. The IRS considers forgiven debt as income, and therefore, you do have to pay taxes on it. You may wish to hire a tax professional to assist you through the process.

Forgiven debt is taxed at the same rate as your federal income tax bracket. So, if your forgiven debt is $15,000 and you’re in the 20% income bracket, you can expect the IRS to bill you for $3,000. Even though you have to pay taxes on the canceled debt, you’re still paying less than the actual debt.

Exceptions to Tax Consequences of Debt Settlement

In most instances, when you have $600 or more in debt that has been forgiven, and you no longer have to pay, you can expect to have to pay taxes on it. However, there are some exceptions to the rule.

Insolvency

If your financial situation was determined insolvent before the debt settlement arrangement, you may not have to pay taxes on the forgiven debt. That means, if it was proven that you were no longer capable of meeting your financial obligations, you may be an exception to the rule. To determine if you’re insolvent, total up your assets and your debts, including the debt that was settled or written off, and if your debts exceed the value of your assets, you could be determined to be insolvent.

Bankruptcy

If your settled debt was canceled in a bankruptcy case, you do not need to report it as taxable income. You do have to report it on Form 982 to show the debt was canceled.

In addition to insolvency and bankruptcy, there may be other canceled debt a consumer can eliminate from their taxable income. They include:

  • Gifts and bequests
  • Certain student loans (doctors, nurses, teachers in rural or low-income areas)
  • Deductible debt (home mortgage interest)
  • Price reduced after purchase (debt on solvent taxpayer’s property is reduced by the seller; the basis of property must be reduced)
Exclusions

Some types of debt may be lowered or reduced, but they must be filed as an exclusion using Form 982. Those debts include:

  • Discharge of debt through bankruptcy
  • Discharge of debt of the insolvent taxpayer
  • Discharge of qualified farm indebtedness
  • Discharge of qualified real property business indebtedness
  • Discharge of qualified principal residence indebtedness

How Does Debt Settlement Affect My Credit Report?

Delinquent debt can negatively impact your credit history. Since you are likely to have defaulted on your account before reaching a debt settlement agreement, information about the default will remain on your credit report for seven years from the date you became 180 days late. 

Although those delinquent reports will remain on your credit for a while, debt settlement is an opportunity to eliminate some of that debt to lower your debt to income ratio, which impacts your credit history more positively. So, debt settlement is one way to move on from the past.

The details of your debt forgiveness plan will not show up in your credit report; it will show up as ‘settled’ rather than paid in full. While having a status of ‘settled’ may not initially look good. It usually does eventually work out in the consumer’s favor. That said, any potential tax consequences of debt settlement can certainly be worth it.

How Can I Do A Debt Settlement?

Debt settlement is usually only a viable option for a consumer if they have defaulted on their loans or what they owe, or are very close to doing so. That means they would need to be about 180 days behind on what they’re due to even qualify for debt settlement. There are two ways to go about doing a debt settlement. You can try to negotiate it yourself or through a debt settlement company.

Debt settlement companies can help consumers with debt settlement. A professional from the debt settlement company works with your creditors to negotiate the debt on your behalf. For a fee, debt settlement professionals advocate on behalf of consumers to get lenders to agree to accept a lump sum settlement that absolves them from having to pay the entire debt.

Should you decide to negotiate for yourself rather than pay a debt settlement company:

  • Make sure to research to have a certain level of foundational knowledge necessary to benefit a debt settlement.
  • Know how much you can afford to pay in a lump sum payment.
  • Withhold payments so you can begin saving for the lump-sum payment.

Creditors are not required to work with you or a debt settlement company, so they don’t have to accept a settlement. However, when the right offer is made, lenders tend to accept the offer since they know they will receive a reasonable payment and can cut their losses and recoup their expenses.

Why Even Do A Debt Settlement?

Debt settlement may seem like a hassle when you consider (1) You or a debt settlement company have to negotiate (it may take several attempts) with creditors; (2) You have to save money to have the lump sum available; (3) The default history that’s already on your credit report, and the fact that (4) You’ll have to pay taxes on forgiven debt. You may wonder why you should even do a debt settlement.

Debt settlement can be a wise choice because (1) It eliminates the threat of a lawsuit, which might force you to pay the full balance; and (2) Paying what you owe is what you agreed to do when you took the debt. Initially, it’s what you owe. The fact that the creditor may allow you to settle for a lesser balance is a good thing.

Conclusion on How Debt Settlement Affects Taxes

In the end, given what you go through, the option to consider a debt settlement should be a last resort and can only be considered if you are in default or close to it. Should you decide to take this route, remember to factor in the taxable income and the taxes you will owe the IRS the next time you do your taxes. Make sure you fully understand the tax consequences of debt settlement before moving forward.

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