Have you ever felt that wave of relief when a debt collector agrees to let you pay off your credit card or medical bill for less than you owe? As liberating as debt settlement may feel, make sure you see the whole picture before celebrating too much. Most debt relief comes with a catch – you’ll probably owe taxes on the amount of debt forgiven.
While paying taxes on settled debts can take away some of your savings, all hope isn’t lost. With proper planning and a few strategic moves, you may be able to eliminate or reduce your tax burden. This guide will walk you through the key facts, exceptions, and smart strategies to avoid getting hit with a surprise tax bill on forgiven debts.
What You Need To Know About Debt Settlement Tax Rules
Let’s start with a quick overview of how cancelled debt gets taxed. This will help you understand why settling debts often increases your taxable income.
Any Debt Over $600 Forgiven Counts As Taxable Income
If a creditor or debt collector cancels $600 or more that you owe, the IRS considers that forgiven debt as taxable income. It doesn’t matter if you paid a company to negotiate the settlement or worked directly with the creditor – the tax rules still apply.
For example, if you settle a $5,000 credit card balance for $3,000, you just had $2,000 of “income” as far as the IRS is concerned. Any amount of debt relief over $600 gets reported to the tax agency.
You’ll Get a Form 1099-C Reporting The Forgiven Amount
Don’t expect creditors to let you quietly settle your debt without a paper trail. If they forgive $600 or more of what you owed, they are required to report it.
You’ll receive an official Form 1099-C detailing the amount of debt forgiven and the calendar year it happened. The creditor sends this form to you and the IRS by January 31st of the year after your settlement.
Canceled Debts Get Taxed At Your Ordinary Income Rate
Now comes the bad news. The IRS treats forgiven debts just like regular income, meaning it gets taxed based on your federal income tax bracket.
For example, say you’re a single filer who earns $50,000 per year from your job. Based on the 2022 tax brackets, your federal income tax rate is 22%. If you have $10,000 of credit card debt forgiven, you’ll owe $2,200 (22% of $10,000) on that amount!
Owing Taxes Can Negate The Savings From Settlements
Between state income taxes and the IRS, taxes on settled debts can eat up a good chunk of the relief you felt. Using the above example, if you saved $10,000 from your creditor but owe $2,200 on taxes, your net savings is only $7,800.
Always account for potential income tax when weighing debt settlement options. The tax man always gets a cut!
Fees For Debt Relief Services Typically Aren’t Tax Deductible
Adding insult to injury, you usually can’t deduct fees paid to debt settlement companies or credit counselors as expenses. Since these are personal debts, the IRS considers associated fees non-deductible personal expenses.
Exceptions Where Cancelled Debt Doesn’t Count As Taxable Income
While most settled debt gets taxed, there are exceptions. Under the right circumstances, you can legally have debt forgiven without claiming it as income or paying taxes.
You May Exclude Forgiven Debt If You’re Insolvent
One major exception is if you’re insolvent when the debt is discharged. Insolvency means your total liabilities exceed your total assets.
For example, if you owe $100,000 total on credit cards, medical bills, personal loans, etc., but only have $80,000 in assets like your car, home, retirement accounts, etc., you’re insolvent.
To avoid paying taxes on forgiven debt, you’ll need to prove insolvency using IRS Form 982. If you can demonstrate your debts exceeded your assets, forgiven amounts don’t count as taxable income.
Filing Bankruptcy Allows Tax-Free Debt Discharge
Filing for bankruptcy offers a legal way to eliminate debt without worrying about taxes. Any debts discharged through bankruptcy aren’t treated as taxable income.
You’ll need to weigh the pros and cons of bankruptcy versus settling debts directly. While bankruptcy can wipe debts out tax-free, it also damages your credit for years. Talk to a bankruptcy attorney to understand your options.
Certain Student Loans Forgiven Aren’t Taxable
Did you know there are government programs that forgive student loans for working in public service fields? The good news is debt discharged through these programs is exempt from income tax.
For example, the Public Service Loan Forgiveness (PSLF) program forgives federal student loans after 10 years of qualifying payments while working full-time for an eligible employer. Any amount forgiven is tax-free.
Other Non-Taxable Forgiven Debts
Here are some other circumstances where you can exclude cancelled debt from your taxable income:
- Debt canceled as a gift or inheritance
- Certain educational loans forgiven for health professionals
- Qualified principal residence debt cancelled before 2026
- Business debts that could be deducted if paid
As you can see, there are quite a few exceptions that allow tax-free debt discharge if you fit the criteria.
Smart Ways To Reduce Taxes On Settled Debts
If your forgiven debts don’t meet an exception, all hope isn’t lost. You still have some options to eliminate or reduce taxes owed on cancelled debts.
Negotiate Just Under The $600 Threshold
Since the $600 threshold triggers tax reporting, try negotiating your settlement just under that amount. For example, see if the creditor will agree to forgive $599 instead of $600. This small change keeps the forgiven debt off the IRS radar.
Use Form 982 To Report Excluded Amounts
If some of your forgiven debt meets an exception, make sure to file Form 982 alongside your tax return. This form allows you to list the forgiven amounts from Form 1099-C and explain why they’re excluded from your taxable income.
Consider Bankruptcy Instead Of Debt Settlement
Filing for bankruptcy often makes more financial sense than debt settlement once you account for taxes. In a Chapter 7 bankruptcy, most unsecured debts can be eliminated without owing income taxes.
Work With A Tax Professional
Consulting a licensed tax pro is wise any time you have debts forgiven. They can help ensure you take advantage of exclusions and have the paperwork to back up tax-free discharged debt.
Request An Offer In Compromise
If taxes on your settled debts end up being beyond your means, you may qualify for an Offer in Compromise. This allows you to settle your tax bill with the IRS for less than the full amount. You’ll need to prove financial hardship.
How To Settle Debt Tax-Free
Now let’s put everything together. Follow these tips when negotiating debt relief to avoid getting hammered with a big tax bill:
Understand The Exceptions
Be aware of circumstances like insolvency and bankruptcy that allow tax-free debt discharge. Consider whether you qualify for an exclusion before finalizing a settlement.
Enlist An Experienced Tax Pro
Work with a tax professional from the start to take advantage of exclusions and properly document charges. Paying for expert help upfront can save you money and headaches later.
Negotiate Directly With Your Creditors
When you settle debt yourself, you avoid paying hefty fees to debt settlement companies. That saves you money that would have gone to taxes on forgiven amounts.
Get Forgiveness Under The $600 Threshold
Ask your creditors to forgive $599 instead of $600 if possible. This keeps the debt off IRS radar screens and may help you avoid paying any taxes on it.
Have A Tax Mitigation Plan
If you can’t exempt the forgiven debt from taxes, take proactive steps to minimize how much tax you’ll owe. Explore options like penalty abatement requests and installment payment plans.
Settling your debts for less than you owe can be a huge relief. But don’t forget to account for the taxman when weighing your options. With proper planning and professional help, you can negotiate debt relief without the shock of a surprise tax bill.