Repairing Credit After Debt Settlement - The Tax Implications of Settling A Debt

Repairing Credit After Debt Settlement - The Tax Implications of Settling A Debt

You may be lucky enough to have all or part of your debt wiped clean when you offer to settle with a creditor. This sometimes happens when you negotiate a reduced payoff and the creditor agrees to designate your account paid in full for less than the original debt. However, your initial peace of mind could leave you with a higher tax bill.

People experiencing financial setbacks sometimes approach their creditors to obtain debt relief, either directly or through an intermediary such a credit counseling company. While this is relatively easy to do and more and more creditors are open to it, you should know that such a debt settlement could have negative tax ramifications.

If you settle a debt with a creditor, or the creditor writes it off, you could owe money to the IRS on that amount. This applies to credit card defaults, property repossession, or money you owe after a foreclosure.

Anytime a credit card company, government agency, bank, credit union, savings and loan, or finance company forgives or writes off $600.+ of debt, they have to submit a Form 1099-C to both you and the IRS. You must them report it as income on your federal income tax returnexcept in these cases:

A student loan canceled because you worked as promised when you took out the loan in a profession and for a specified employer.

A mortgage on your principal home of less than $2M if you file single or jointly with your spouse ($1M if you file individually with your spouse) that was wholly or partially forgiven between 2007 and 2012.

A nonbusiness debt canceled before 2007 as a result of Hurricane Katrina.

A canceled debt that would have been deductible if you had paid it.

A debt discharged in Chapter 11 bankruptcy.

Cancellation or write-off of a debt intended as a gift (highly unlikely).

You were insolvent (your debts exceed the value of your assets) before the creditor agreed to waive or write off the debt. You can avoid reporting the debt as income only to the extent that you were insolvent.

To claim an exception, you need to file an IRS Form 982: Reduction of Tax Due to Discharge of Indebtedness form. This form can be complicated - especially if you are claiming the insolvency exception. Consult an accountant to ensure it is properly done. They can also help you on your tax return.

A debt settlement where your creditor settles for less than the original amount can affect your tax liabilities. While this may appear to eliminate all your problems in the short term, it can complicate your tax situation. Hiring a competent accountant to review your circumstances can guarantee that you stay on the right side of the IRS.

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