Effects Of Debt Settlement On Your Taxes

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If you’re overwhelmed by aggressive collection calls, you may consider settling your debt for less than you owe. This is a good option for people in over their heads, but it doesn’t come without its difficulties. Read on to find out what debt settlement means for your taxes.

What is debt settlement?

Debt settlement is an agreement between the creditor and the borrower. Both parties agree on a reduced amount to pay off the debt in full. The borrower gets the advantage of paying a smaller amount than he owes, and the creditor gets paid at least something instead of having to write off the entire balance.

Of course, debt settlement doesn’t come without its costs to the borrower. Debt settlement will appear on your credit report as such and hurt your credit score. Also, you may have to pay taxes on the difference between what you paid and what you owed. Yes, the amount of debt you didn’t pay is generally reported to the IRS as income.

The tax implications of settling your debt

While settling your debt may be a huge relief, you need to be prepared to pay taxes on the amount settled. Depending on the type of debt, your creditor may send you a 1099-C cancellation of debt tax notice. This information will be reported to the IRS, and you'll need to report it as "other income" on your tax return. One exception is for student loan debt forgiveness: The American Rescue Plan that President Biden signed into law in March 2021 exempts student loans forgiven through December 2025 from being considered gross income.

While you might be left on the hook paying taxes, you have a few options for tax relief if that's the case.

Even if you don’t receive a 1099-C, you may still be legally required to report canceled debt as income. As with anything else, there are exceptions; you can find the exceptions and more information on IRS Publication 4681.

How much do I have to pay?

This income is taxed at your normal tax rate, which range from 10% to 37%, based on your taxable income. The United States has a progressive tax rate, meaning that the tax percentage increases as the taxable base increases.

What if I choose not to report it?

Legally, you must report all taxable income received — and this includes your debt settlement amount. If a 1099-C is issued to you, the IRS is also receiving a notice of income, and you can be penalized for not reporting. You’ll have to pay not only the tax you owe, but also fines.

If you don’t receive a 1099-C, the IRS won’t receive this information either. However, if you’re chosen for an audit for any reason, this will likely be discovered. Stay on the right side of the law and report all income. It isn’t worth it to break the law and underreport.

Forgiven Mortgage Debt After Foreclosures

This rule applies even to debts you owe after a foreclosure. In this situation, the law can seem especially cruel: Not only have you lost your property, but you might also have to pay income tax on the difference between what you originally owed the lender and what it was able to sell your property for (called the "deficiency") if the deficiency is forgiven.

To keep financially strapped homeowners from taking a second hit at tax time, Congress passed the Mortgage Forgiveness Debt Relief Act in 2007 and I.R.C. §108(a)(1)(E) was added to the Internal Revenue Code, creating the Qualified Principal Residence Indebtedness (QPRI) exclusion. Under this exclusion, some taxpayers don't have to pay taxes for mortgage debt forgiven during 2007 through 2025, as well as debt discharged after that if a written agreement was entered into before January 1, 2026.

The exclusion provides tax relief if your deficiency stems from the sale of your primary residence (the home that you live in). Here are the basic rules:

Loans for your primary residence. If the loan was secured by your primary residence and was used to build, buy, or improve that house, as of December 31, 2020, you may generally exclude up to $750,000 ($375,000 if married and filing separately). Before this date, taxpayers could exclude $2 million ($1 million if you're married and filing separately) of forgiven debt.
So, if you qualify for the exclusion, you don't have to pay tax on the deficiency. The exclusion also applies to refinances, but only up to the amount of the original mortgage principal before the refinance.
If you don't qualify under this exclusion, you might still qualify for tax relief. For example, if you can prove you were legally insolvent, you won't be liable for paying tax on the deficiency. See "Exceptions on Reporting Income," below, for details on the insolvency exception.
Loans on other real estate. If you default on a mortgage that's secured by property that isn't your primary residence—for example, a loan on your vacation home—you'll probably owe tax on any deficiency.
Loans secured by but not used to improve primary residence. If you take out a loan, secured by your primary residence, but use it to take a vacation or send your child to college, you will likely owe tax on any deficiency.

IRS Reporting

Any financial institution that forgives or writes off $600 or more of a debt's principal (the amount not attributable to interest or fees) must send you and the IRS a Form 1099-C at the end of the tax year. These forms are for reporting income, which means that when you file your tax return for the tax year in which your debt was settled or written off, the IRS will make sure that you report the amount on the Form 1099-C as income.

Even if you don't get a Form 1099-C from a creditor, the creditor might very well have submitted one to the IRS. If you haven't listed the income on your tax return and the creditor has provided the information to the IRS, you could get a tax bill or, worse, an audit notice. This could end up costing you more in IRS interest and penalties in the long run.

Exceptions to Reporting Income

The Internal Revenue Code has several reporting exceptions. For example, if the financial institution issues a Form 1099-C, you don't have to report the income on your tax return if you were insolvent before the creditor agreed to settle or write off the debt.

Insolvency means that your debts exceed the value of your assets. To figure out whether or not you were insolvent, you'll have to total up your assets and your debts, including the debt that was settled or written off.

Example 1: Your assets are worth $35,000 and your debts total $45,000, so you are insolvent to the tune of $10,000. You settle a debt with a creditor who agrees to forgive $8,500. You do not have to report any of that money as income on your tax return.

Example 2: Your assets are worth $35,000 and your debts still total $45,000, but the creditor writes off a $14,000 debt. You don't have to report $10,000 of the income, but you will have to report $4,000 on your tax return.

If you conclude that your debts exceed the value of your assets, include IRS Form 982 with your tax return. You can download the form off the IRS's website at www.irs.gov.

Consider Talking to an Attorney

Tax laws are complicated, and an exception or exclusion might save you from having to pay taxes on canceled debt. If you have questions about whether your forgiven debt is taxable, consider talking to a tax attorney.