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Tax Implications of Settling Your Debt
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There’s no going around it: Dealing with substantial amounts of debt can be stressful. But when it comes to finding a solution, you have options.
For example, you could take out a personal loan, work with a credit counselor to help you better manage your debt or ultimately settle your debt. Settling your debt could mean working with a debt relief company or service that negotiates with creditors on your behalf. The end goal is to settle your debt for less than what’s owed.
But there are various risks and implications in settling your debt. It can affect your credit and your taxes. Read on to learn more.
The tax implications of settling your debt
According to the IRS, debt that is forgiven or discharged for less than the amount you owed is considered canceled. The IRS also considers this to be a form of income, and as such, this canceled debt is still taxable. Thus, you must still report it on your tax return for the year the settlement, or cancellation, occurs.
The creditor will likely send you a 1099-C form with the cancellation amount and date. You’re then responsible for reporting this taxable debt as “other income” from the cancellation of debt on Form 1040.
Because the IRS treats your canceled debt as income, you can usually expect to be taxed at your normal tax rate. Failing to report it as such could result in fines, penalties or even an audit from the IRS.
“When someone has debt canceled (a generally positive occurrence), they often get a nasty surprise come tax time when they receive a Form 1099-C. This catches many people off guard and can wreak havoc on a person’s tax bill – especially if they are on Obamacare or receive some sort of public assistance,” said Micah Fraim, a CPA and tax accountant in Roanoke, Va. “As with anything tax-related, the options available will vary considerably from person to person. If the amount of debt canceled is significant, it would be advisable for the taxpayer to seek out a tax professional to go over their options and discuss the tax implications of the course of action chosen.”
You may not need to report canceled debt as income
Just when you think you can breathe a sigh of relief about having your debt settled, learning that you need to report it as taxable income is probably the last thing you want to hear. However, under Internal Revenue Code Section 108(a) there are certain exceptions to this requirement:
- Insolvency: Insolvency is defined as the inability to pay debts when they are due, either because you don’t have the money or the amount of your debt exceeds the value of your assets. If you believe you are insolvent, you should first begin working with a debt counselor or debt management company to try to negotiate a settlement. Some of this canceled debt may end up not being taxable; as such, working with a tax professional can be worthwhile to ensure you are reporting the correct amount of taxable canceled debt income.
- Bankruptcy: According to the IRS, debts discharged through bankruptcy are not considered taxable income.
Foreclosure used to also be an exception thanks to the Mortgage Forgiveness Debt Relief Act of 2007, in which taxpayers were generally allowed to exclude forgiven mortgage debt relief due to foreclosure from their tax return. However, this ended with mortgage debts discharged through 2016.
“If you received a cancellation of your mortgage in 2018, this is taxable income unless you went through bankruptcy or can except some or all due to insolvency,” said Beth Logan, an enrolled agent with Kozlog Tax Advisers in Chelmsford, Mass.
Moving forward: Tips to avoid debt
While debt settlement can relieve financial stress to a certain extent, it’s not the most ideal predicament. There are various habits you can adopt to help you avoid going down this road and ultimately take charge of your finances.
- Pay your bills on time. Not only can accumulated past due bills contribute to amassed debt, but payment history is the most important factor that contributes to your credit score. Failing to pay your bills on time can also lead to late fees, penalty APRs and the cancellation of 0% introductory rates. If you suspect you might not be able to pay a bill on time, contact the lender to try to negotiate a payment plan or change your payment due date.
- Create and stick to a budget. Tally up all your monthly expenses, including rent, bills, subscriptions and grocery expenses. Subtract these expenses from your total monthly income and determine how much of the remainder should go to emergency and retirement savings before spending on entertainment and fun.
- Track your spending. Take a close look at your bank statements over the last several weeks or so to figure out where your weak points are. Did you eat out more than you stayed in? Did you go on one too many shopping trips and end up with shoes you didn’t really need? Once you identify these areas, give yourself some self-imposed limits (such as only eating out twice a week, perhaps) and start shopping with a list so you can check yourself before doing any damage going forward. Consider also using an app like Mint to keep an organized budget and easily log expenses and purchases.
- Enroll in autopay. After you’ve figured out your monthly budget, enroll in autopay for whichever of your bills allow it. Having your bills immediately paid on time will not only help you easily avoid unnecessary fees and penalties, but also see how much you truly have left for discretionary spending each month.
While debt settlement can be a reputable solution for paying down your debt, it isn’t without its risks, especially when it comes to potential tax consequences. Be sure to enlist professional help to ensure you’re going about it appropriately come tax time, and take steps to take charge of your finances to avoid returning to this situation in the future.