What Your Taxes Will Look Like If You Pay Off Your Debt

Debt settlement is a viable option for many struggling to get back on their feet financially. However, if you aren't careful, the tax consequences of settling your debt could be a major financial setback. When you settle your debt, you make a reduced payment to your creditor in exchange for canceling the rest of your obligation. Debt forgiveness may appear to be a simple solution, but it is considered taxable income by the Internal Revenue Service. If the amount of debt canceled is $600 or more, the creditor must file IRS Form 1099-C, Cancellation of Debt, with you and the IRS. You must include the amount of canceled debt on your tax return as income, and the IRS requires you to report it using this form. However, some possible exemptions include debts that are forgiven due to insolvency or discharged in bankruptcy. To make sound financial decisions, you must know the potential tax implications of settling your debt. Talking to a tax expert can help you avoid or reduce tax problems.

Debt Forgiveness and Taxable Income

Debt settlements often involve the creditor waiving a portion of the debt the debtor owes; the IRS may treat this as income. Cancellation of debt is treated as income by the IRS because it is money you no longer owe. If you owed $10,000 on a credit card but could only pay $5,000 off, the remaining $5,000 would be considered canceled the debt and could be subject to taxation.

Form 1099-C, Debt Cancellation

Creditors must file Form 1099-C, Cancellation of Debt, with you and the IRS if the amount of debt canceled is $600 or more. You must include the amount of canceled debt on your tax return as income, and the IRS requires you to report it using this form. As the IRS will have a record of the canceled debt, you should not disregard a Form 1099-C if you receive one because failure to do so could result in penalties and interest.

Canceled Debt Exceptions and Exclusions

Though in most cases, a debt cancellation will result in taxable income, certain circumstances may warrant an exemption, such as when the debt is discharged in bankruptcy or forgiven due to insolvency.

Bankruptcy Discharged Debt

A bankruptcy-discharged debt is not taxable income. Debts are released from your responsibility when you declare bankruptcy. Debts that have been discharged are not considered taxable income by the IRS.

Debt Forgiven Because Of Going Broke

The same holds for insolvency-related debt cancellations. To be insolvent means to have more debts than assets and to be unable to meet current debt payments. If you can prove that you could not pay your debts when they were forgiven, you may be able to exclude the amount of debt forgiven from your taxable income. Complete IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to prove insolvency. With this form, you can figure out how much of your forgiven debt is exempt from taxation. You are expected to submit a balance sheet and a list of assets and liabilities to back up your insolvency claim.

Tax Reporting Requirements

If your canceled debt constitutes taxable income, you must include the amount in your tax filing. Form 1040, U.S. Individual Income Tax Return, Line 8: Cancellation of Debt Amount. Form 982, Reduction in Tax Attributes Owing to Discharge of Indebtedness, must be filed with the Internal Revenue Service (IRS) if you believe you are entitled to a deduction or exemption.You must report any debt cancellations on Form 1099-C, Cancellation of Debt, that you receive. Review the form carefully to ensure the reported amount of canceled debt is correct. If you think the creditor has entered the wrong amount, you can ask for a new form to be filled out with the correct information.

Conclusion

It would be best to consider the tax repercussions of any debt settlement options before making any final decisions. Debt settlements often involve the creditor waiving a portion of the debt the debtor owes; the IRS may treat this as income. Discharged debt in bankruptcy or insolvency-related debt forgiveness are two possible exceptions to this rule. It's important to talk to a tax expert before settling your debt to ensure you don't incur unanticipated tax penalties. You can get advice from them on handling the situation and what steps will have the least impact on your taxes. To file your taxes correctly, you should also keep meticulous records of all debt cancellations and supporting documents. Although debt settlement may help you get back on your feet financially, you should be aware of the tax consequences before making any decisions. If you consult a tax expert and keep yourself informed, you can easily settle your debts and pay as little tax as possible.