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Debt Settlement Taxes: Income Tax Consequences of Settling Debt

There are a number of ways through which cash-strapped consumers can eliminate debt. One such method that has been in use for several years is debt settlement.

Long before the recession hit, creditors have negotiated with consumers to pay off past-due balances. When the recession's effects were first felt, millions of Americans began to suffer financial hardship. As a result, many lenders and creditors began accepting "deals" to recoup some of the money owed to them, while simultaneously canceling or forgiving any remaining balances. When this occurs, the consumer benefits by paying off a debt, while the lender receives a portion of the outstanding balance.

What many consumers are unsure of is how that forgiven debt is handled at tax time. Here is a look at how canceled debt affects your taxes:

Canceled Debt

When an account's past-due balance is owed, the lender grows concerned about whether or not it will be possible to collect that debt. In some cases, balances are never repaid, resulting in a loss for the lender. To avoid this, many lenders will work with the delinquent account holder to negotiate a lower pay-off amount. The difference in what is owed and the full amount required to pay off the account is considered canceled debt. Once the agreed-upon payoff amount is received by the lender, the account is considered paid.

Taxes and Canceled Debt

Canceled debt of $600 or more may be taxable unless certain qualifying exceptions can be proven. The amount forgiven is considered income and must be reported by the taxpayer. When a federal government agency or financial institution cancels a debt, they will report the amount to the IRS and send the account holder a Form 1099-C. The form, titled Cancellation of Debt, will provide the amount canceled and other information regarding the forgiven debt. Unless the taxpayer qualifies for an exception or exclusion, this information must be included in that year's income tax return.

Exceptions and Exclusions

The most common form of debt that is forgiven through this method is credit card debt; however, there are other forms of debt that may be forgiven and subsequently taxed. To determine if forgiven debt is taxable, consider this information provided by the IRS:

  • Gifts or bequests specifically excluded from income by law are not taxable.

  • Certain qualified student loan debts may be considered an exception to inclusion of gross income.

  • Seller initiated reduction of qualified purchase price may not be taxable.

  • Debt canceled due to insolvency, Title 11 bankruptcy, qualified farm indebtedness, qualified principal residence indebtedness or qualified real property business indebtedness may not be taxable.

It is important to note that the IRS requires proof of exclusions and exceptions. For example, a taxpayer claiming insolvency will not only have to prove that he was unable to pay the debt in full, but he must also provide proof of all assets at the time of the forgiven debt. The amount of debt excluded from inclusion for income tax purposes cannot exceed the insolvency amount. Therefore, any amount beyond the insolvency amount that is forgiven will be considered taxable income.

Depending on the individual situation, certain forgiven debts may be considered non-taxable, helping consumers to eliminate debt without the added concern of owing taxes. In cases of serious financial hardship, negotiating with a lender to reduce the amount owed can be a successful way to pay down debt and begin working toward a more secure financial future.

To learn more about which types of forgiven debt are taxable and which debts may be considered income, taxpayers are urged to review IRS tax laws or speak to a tax professional.

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