Tax Consequences Of Debt Settlement

When weighing the various options available for debt settlement, one should factor in the debt settlement tax as well. Firstly, unlike bankruptcy, debt settlement ensures that you pay back around 50 per cent of your debt to your creditors. In return, your creditors forgive the balance 50 per cent of the debt.

Tax Liability

However, creditors are bound to report to the IRS if they have forgiven $600 or more in debt to an individual or group. In such cases, the IRS can tax the amount forgiven as income. There are a few exceptions by which you can avoid this tax.

Insolvency Clause

This forgiven debt – if over $600 -- is taxed as income only if your assets are more than your liabilities. For purposes of calculating your assets, mainly your home equity is taken into consideration. If this is greater than your liabilities, you will have to pay a tax on the forgiven portion of your debt. However, if your liabilities are greater than your assets, that is, if your net worth is in the negative, you do not have to pay tax on your forgiven debt. So, do check out your insolvency status before you pay tax on forgiven debt. For this purpose IRAs and 401K holdings may not be added to your assets. This is good news for those who are almost solvent.

To get the IRS to waive your debt settlement tax you have to fill out form 982 and petition the IRS for a waiver stating that you are insolvent.

Solvent Debtors

Even those who have to pay tax on forgiven debt benefit from a debt settlement as the tax they pay will be less than the forgiven amount. This difference can help a person become debt free a lot sooner. So, do not forego the opportunity to avail of debt settlement just because you might have to pay a small percentage as tax.

For those debtors who might be solvent once the debt is forgiven, it makes sense to see if it is financially viable to opt for debt settlement when you factor in the tax as well. This is over and above the debt settlement fee that companies charge for negotiating your debt settlement.

Form 1099-C

Whether you are solvent or not, if you opt for debt settlement you have to obtain Form 1099-C from your creditors even as they cancel your debts. You need to file this with the IRS and pay any taxes that are due on the forgiven amount of your debts.