Do I Have To Pay Taxes on Debt Settlement?

Debt settlement often comes as a huge relief: knowing there’s a way out of debt can lift a huge weight off your shoulders. It feels great to have your debt settled, canceled or forgiven, but you should be aware that there are tax implications of debt settlement.

Settled debt is considered income by the IRS, so you’ll have to pay income taxes on the forgiven amount. Creditors will send you a 1099-C form if the amount is greater than $600. While there are some exceptions, like certain student loan debt forgiveness programs, you’ll likely have to pay some taxes on debt forgiveness.

What is 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 potentially reduce your overall debt burden. After all, many creditors would prefer to receive partial payment than nothing. Once your debt has been settled, you’ll make a single monthly payment — which is hopefully a more manageable amount — to the debt settlement company instead of to each individual creditor.

You could also cut out the middleman and negotiate your debts directly. Your creditor may agree to reduce the amount owed to avoid sending the debt to collections.

Tax implications of debt settlement

If $600 or more of your debt is forgiven or canceled, you’ll have to pay taxes on the amount forgiven. You’re required to report the forgiven debt on your taxes, and your creditor will send a Form 1099-C showing the amount that was canceled and when it was canceled.

Since debt forgiveness is considered to be income by the Internal Revenue Service (IRS), you’ll have to file the forgiven amount as “other income” on your tax return and pay the normal income tax rate. Suppose you earn $50,000 and have a $10,000 debt canceled. You’d have to pay 22% — or $2,200 — on the portion of your gross income from your debt cancellation.

Often, debt forgiveness means that you’ll end up owing the IRS money. If your tax burden is greater than you can reasonably pay, you may qualify for tax debt relief.

Debt cancellation tax exceptions

Fortunately, the IRS has tax exemptions for debt cancellation. You might not have to pay income taxes on the amount if one of the following situations apply:

• The debt is canceled as a gift, inheritance or bequest
• Student loans that are canceled if you work for a certain time period for certain classes of employers
• Other educational loan forgiveness programs for providing health services in certain areas
• Certain student loan discharges from 2021 to 2025
• Discharged amounts from certain federal, private or educational student loans
• Debts that would be deductible if you had paid them as a cash basis taxpayer
• Qualified purchase price reductions given by the seller of a property

In many cases, cancellation of debt does not count as taxable income. For example, if you spend a decade working toward Public Service Loan Forgiveness (PSLF) as an eligible employee and your loans are forgiven, you won’t have to pay income taxes on the forgiven amount. For significant debts like student loans, tax-free debt forgiveness can really help your financial situation.

There are also situations in which canceled debt doesn’t count against your gross income:

• Debt canceled as part of a Chapter 11 bankruptcy
• Debt canceled to the extent that the debtor’s liabilities exceed their total assets
• Qualified farm indebtedness
• Qualified real property business indebtedness
• Qualified principal residence indebtedness discharged before 2026

Consult with a tax professional

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.