Do I Have to Pay Taxes on Debt Settlement?
If you’re struggling with debt, one option is to use a debt settlement company, which may be able to help you negotiate terms with your creditors and reduce your overall debt burden.
While it feels great to have your debt settled, canceled or forgiven, you should be aware that you may need to pay taxes on debt settlement.
- Settled debt that exceeds $600 is typically considered taxable income by the IRS.
- Some types of debt are excluded from federal taxation, including certain student loans.
- The amount of tax you’ll have to pay on cancelled or forgiven debt depends on your tax bracket.
Tax implications of debt settlement
When you settle debt for less than the full amount owed, the forgiven amount may be considered taxable income by the IRS. However, tax implications depend on both the type and amount of debt being forgiven.
In general, debt cancellation of $600 or more is considered additional income and will need to be reported on your annual tax return. Once a debt settlement agreement has been reached, your creditors will send you a 1099-C tax form, which you can use to report the amount of canceled or forgiven debt to the IRS.
The amount of tax you’ll pay on debt settlement depends on your tax bracket, filing status and the deductions you select. For example, let’s say you settled $5,000 in credit card debt for $2,500. In this scenario, the IRS would consider the $2,500 you saved as taxable income. If you file individually with an annual income of $60,000, your forgiven debt would be taxed at 22% — meaning you would owe the government $550 for your debt settlement.
Of course, whether you’ll have to pay this money out-of-pocket will depend on other tax factors, including whether you typically owe money or receive a refund during tax season.
Situations where debt is discharged tax-free
While you can generally expect to pay taxes on debt settlements, there are some exceptions. For instance, some student loan forgiveness programs, including Public Service Loan Forgiveness (PSLF), are exempt from taxation.
Other exceptions include:
- Debts canceled as a gift, inheritance or bequest
- Student loans that are canceled when you meet certain provisions based on the length of your employment in a specific sector
- Debts forgiven in specific situations as part of The American Rescue Plan Act, which modified the treatment of student loans for discharges from 2021 to 2025
- Debts discharged from certain federal, private or educational student loans under certain payment assistance programs
- Debts that would have been deductible if you had paid them outright
- Qualified purchase price reductions given by the seller of a property
Canceled debt related to farm operations, business property and mortgage debt may also be excluded from taxation for qualified individuals. To find out if the debt you settled can be excluded from federal taxes, you can fill out IRS Form 982.
How to avoid or lower taxes on settled debt
Even if your debt does not fall into one of the categories listed above, there are some legal strategies you may be able to use to avoid or minimize tax liability on debt settlements, including:
- Filing for bankruptcy: If you have too much debt to be able to negotiate a reasonable deal with your creditors, filing for bankruptcy might be a better option than working with a debt settlement company. Debts canceled as part of a Chapter 11 bankruptcy do not count against your gross income.
- Proving insolvency: Being insolvent means that your debts exceed your total assets, meaning you are unable to pay off your debt. If you are considered insolvent by the IRS, you may be exempt from paying taxes on some or all of your canceled debt.
- Planning ahead: If you aren’t able to avoid being taxed entirely, taking the time to plan ahead and prepare for tax season is your best option. Before agreeing to debt settlement, take the time to understand your tax bracket and how debt settlement might affect it. For example, if settling debt will push you into a higher tax bracket, it might be best to coordinate debt settlements over multiple tax years to minimize the impact.
How to get started with debt settlement
If your debt burden feels overwhelming, it might be worth looking into debt settlement despite the tax implications. As we’ve covered, you can get started by working with a debt settlement company. You could also cut out the middleman and negotiate your debts directly with your creditors. Some may agree to reduce the total amount owed to avoid sending the debt to collections. After all, many creditors would prefer to receive partial payment than no payment.
If you’re concerned about how debt settlement programs can impact your tax liability, your best course of action is to contact a tax professional who can help you determine whether it’s worthwhile to pursue debt settlement. They can also help you plan for eventual tax payments with strategies like installment plans or filing deadline extensions.
Frequently asked questions
While we’re discussing how debt settlement can affect your tax bill, it’s important to note that settled accounts can also impact your credit score.
Though settling your debts is better than not paying them at all, settled accounts tell the credit bureaus (and any potential lenders) that you were unable to meet the terms of your loan or credit agreement. Settled accounts may remain on your credit reports for up to seven years.
You’ll need to report any canceled debt on your tax return. The IRS considers forgiven debt taxable income if it exceeds $600. Creditors that forgive more than this amount will typically send you IRS Form 1099-C, which outlines the forgiven amount and other related details.
When tax season arrives, you’ll report the canceled debt as “other income” on your tax return, using the information included on Form 1099-C. If your debt relief qualifies for an exclusion, you’ll still need to report it to the government, using Form 982 to determine the amount of debt that can be excluded from your gross income.
As we’ve covered, debt forgiveness often results in owing the IRS money, and if the forgiven debt will send you into a higher tax bracket, it could have a significant impact on the amount you owe.
If your tax burden is great, meaning you owe more taxes than you can realistically afford to pay in a lump sum, you may qualify for tax debt relief. Just keep in mind that your debt may accrue interest and penalties, increasing the total amount you’re required to repay over time.
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