How Does Debt Settlement Impact Your Taxes?

Debt Settlement and Taxes

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Overwhelming debt is a huge issue for countless Americans. To help solve the problem, many people enroll in debt settlement programs or find some other way to achieve loan forgiveness. While these tactics can help relieve the monthly burden of unaffordable loan payments, you may be surprised at one unhappy consequence: a much larger income tax bill.

Whether you’ve already reached a debt settlement or are considering a way to negotiate your debt, keep reading. We’ll tell you everything you need to know about how debt settlement can affect your taxes. And while this is a great jumping off point, don’t forget to consult a tax professional to find out about your specific situation.

What money is taxable from debt settlement?

Any amount of principal you settle from an existing debt is considered by the government to be taxable income. For example, if you owed a credit card $20,000 and settled for $8,000 then the amount you didn’t pay would count as taxable — in this case, $12,000.

That’s a lot to pay extra tax on. If you’re in the 25% tax bracket, you’d owe an extra $3,000 — and that’s just in federal tax. Plus, if you’re on the border between two tax brackets, your forgiven debt amount could bump you into the next bracket. That would result in paying a higher tax rate on part of your income.

Now here’s where things get even trickier. Settled debt only counts as taxable income if it’s part of your principal balance. Any settled amount that was charged due to interest or late fees does not count.

Why is settled debt considered taxable income?

It may seem outrageous that the federal government considers forgiven debt to be personal income. But when it comes down to it, you spent money that you didn’t end up paying back. So whether it was on credit cards or hospital bills, it basically comes down to money that was given to you since you couldn’t repay.

And even though you never got a paycheck, or if the amount spent was spread out over several years, the government views it as income in the year the debt was forgiven.

If you’re negotiating debt forgiveness with several creditors, it may be worth asking your accountant about spreading out the settlement process over more than one year. At least then your tax burden is spread out as well.

What federal tax form do you need to use?

Before tax season, you should receive a form from your creditor called a 1099-C. This must be sent if the forgiven amount is over $600 but some creditors send it no matter how small you settlement was. You then list the amount from your 1099-C on your federal form 1040 under “Other income.”

If for some reason you don’t receive a 1099-C form from your creditor, you’re still responsible for listing that forgiven debt as income. Go through your files and verify the exact amounts you had forgiven so that your 1040 tax form is completely accurate.

If you’re not sure or can’t find your paperwork, call the creditor and ask for a copy of the missing documentation. You’ll want to have everything in order in case you’re selected for a tax audit.

Are there any exceptions?

There are a couple of exceptions to claiming your forgiven debt as income — but it’s not an easy road either way. The first option is to ask your creditor to claim the forgiven amount as a gift. Honestly, it’s difficult to have success with this method.

The only other option is if you can prove you were insolvent prior to receiving debt forgiveness. Financial insolvency means your total debt outnumbered your total assets. This is a technical process, so you’d definitely want to get in touch with an accountant or tax attorney before you move forward. If you do choose that path, make sure you also file a Form 982 with your taxes.

Is your credit also impacted during debt settlement?

Yes, debt settlement absolutely affects your credit score. In fact, most reputable debt settlement companies are quite upfront about this. If they’re not, it’s a red flag and you should probably work with someone else.

When going through a debt settlement company, they typically advise you to stop making payments on your credit card and loan debt. You instead use that money to fund your settlement account. But what that does is add multiple late payments to you credit report, which causes a huge drop in your score.

Once you settle your debt, that is also listed on your credit report and can have a negative impact.

If you need help repairing your credit, we’re here to help. Reach out today to learn how.

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