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How does debt settlement impact your taxes?

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Debt settlement can be an incredibly beneficial step forward in a debt payoff journey. Still, it’s essential to understand all the intricacies of debt settlement. One of the most important questions you should be asking yourself is, “How does debt settlement affect your taxes?” Read on to learn the answer—it might surprise you.

What is debt settlement?

Debt settlement, also known as debt forgiveness, is when a borrower and lender agree to settle a debt for less than what’s owed. This process is typically done when a borrower is behind on payments.

The lender will want to close out the debt to reduce their risk of further missed payments, so they agree to “settle.” The borrower makes a lump sum payment on a reduced balance that both parties have agreed to. 

In 2020, Americans with vehicle or credit card debt in forbearance increased by 1.5 to 2 percent. For individuals struggling to make their payments, debt settlement is a convenient option that allows them to get out of their loan agreement. 

Be prepared to pay taxes on the settled debt

Debt settlement may sound like the perfect solution. You don’t have to pay everything you originally owed, and you walk away debt-free. However, there are strings attached—debt settlement does impact your taxes. 

If more than $600 of debt is forgiven, it’s considered income by the IRS and is therefore taxable. If you have $22,000 in credit card debt and settle for a payment of $12,000, then you can be taxed on the difference of $10,000. 

How much you pay in taxes will depend on what income tax bracket you’re in. The IRS has seven tax brackets. Let’s say you fit into the tax bracket of 22 percent (the rate for individuals earning over $40,525 or married couples earning over $81,050, as of 2021). At 22 percent, you’ll owe the IRS $2,200 in fees for your $10,000 debt settlement. If you can’t afford this payment, you might find yourself in tax debt. 

After agreeing to debt forgiveness, your creditor will provide you with a 1099-C form so you can claim the income on your next tax return. The form will include the specific amount of debt that was forgiven. 

Even if you don’t receive a 1099-C form, you should still report the debt forgiveness as income (if it exceeds $600). The creditor might have submitted a 1099-C form to the IRS and you just didn’t receive a copy. If this happens and you don’t report the income, you can be subject to IRS penalties or an audit. 

Note that debt settlement taxes apply even to foreclosures. In a foreclosure case, you might have to pay income tax on the difference between what you originally owed your mortgage lender and what they were able to sell your property for.

In 2007, Congress passed the Mortgage Forgiveness Debt Relief Act. This act had a Qualified Principal Residence Indebtedness exclusion. This stated that some individuals who had their mortgage debt settled between 2007 and 2020 don’t have to pay taxes on the amount forgiven. Not everyone qualifies for this exception, but it’s worth investigating if you can take advantage of this legislation.

If you settled your mortgage debt outside of the 2007 to 2020 time period, you likely would have to pay income tax on the forgiven amount. 

Why is settled debt considered taxable income?

Usually, getting a loan doesn’t count as income, so what makes debt settlement different? Well, you borrowed money, and debt settlement means you don’t pay it all back. So you received additional money that needs to be accounted for. 

When a creditor has a loan go into delinquency, they can eventually write off the debt. The same applies to a debt settlement. Your creditor can claim the difference between the original loan and what they received in their final payment as “lost income.” They do this to reduce their tax burden.

So, in an effort to collect taxes on this money, the IRS passes the costs on to the borrower. From the IRS’s perspective, not paying your full loan is like being given money, so it should be taxed. 

Are there any exceptions?

Yes, there are exceptions, and some people may be able to skip paying income taxes on their forgiven debt. The first exception is if you can get your creditor to claim the difference as a gift. However, a creditor will rarely agree to this approach. 

The second option is to prove you were insolvent before receiving debt forgiveness. The insolvency test is pretty straightforward. At the time of your debt settlement, your liabilities had to exceed the fair market value of your assets. 

If you choose to pursue the tax exemption route, there are two crucial steps you should take:

What will happen if you don’t report the debt settlement?

As debt settlement is considered income, it holds the same consequences as not paying your full taxes. Note that if you received a 1099-C form from your creditor, it’s guaranteed they submitted one to the IRS too. Not accounting for this income in your tax return will result in additional fees. 

As we mentioned, don’t assume that not receiving a 1099-C form means the IRS didn’t get one either. It’s to the creditor’s advantage to file this form because they receive a “lost income” tax break for the amount. 

When you don’t pay your taxes correctly, you can incur late fees, negligence penalties, interest penalties and civil fraud penalties. If you’re charged and convicted of tax evasion, it can result in up to five years in federal prison and a $250,000 fine. 

The risks are too high, and it’s in your best interest to pay the taxes you owe. Even if the IRS doesn’t catch you initially, an audit in the future could catch everything. 

Does debt settlement also affect your credit?

Another critical factor to consider when considering debt forgiveness is how it impacts your credit. When you pay off your debt for less than what was owed, it shows up on your credit report and can lower your credit score by several points. This negative item can stay on your credit report for up to seven years. 

The debt settlement process will also negatively impact your report. Most debt settlement companies that help you through the debt forgiveness process advise you to stop making payments on your debt for a few months.

This serves two functions: First, it puts your debt into delinquency, making the creditor more willing to engage in debt settlement conversations. And second, the debt settlement company will ask that you put the money you would have been paying every month into an account to start collecting your lump-sum payment. 

Of course, missing several months of payments and having your account(s) go into delinquency status will cause your credit score to suffer. A reputable debt company will explain all this to you. But while your credit will initially suffer, it can bounce back over time if you consistently make good credit decisions. 

Work with professionals to decide what you should do

Debt settlement may or may not be worth it for you, depending on tax implications and other factors, such as losing assets or property. You should consult with debt settlement professionals, tax professionals and other financial professionals who can help you. As these professionals have been through this process many times before, they’ll be able to help you evaluate the benefits and drawbacks of debt settlement for your situation. 

Ultimately, debt settlement is a very personal choice and should be evaluated on a case-by-case basis. If debt settlement doesn’t seem like the best choice, you can investigate other options for dealing with debt. If you think you can manage monthly payments, a balance transfer or a debt consolidation loan may be more appropriate. 

The most important thing to do is find a solution for your debt as soon as possible. Act fast, start negotiating with your creditors and remember to keep your future taxes in mind. Contact the credit repair advisors at CreditRepair.com to learn more about items that can negatively affect your credit report.

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