Debt Settlement & Income Taxes - What You Need To Know
Debt settlement has become a popular approach to resolving
problem debts without having to file bankruptcy. With this
approach, creditors agree to accept a portion of what you owe
(usually around 50% or less) to settle the account, and the
remaining balance is forgiven. This technique will certainly
continue to grow in popularity now that the new bankruptcy law
makes it tougher to fully discharge debts in a Chapter 7
bankruptcy.
As with anything, there is no free lunch, and creditors are
required to report canceled debts to the IRS on Form 1099 (when
the canceled balance is $600 or greater). Therefore, the
possibility exists that you may owe taxes on the forgiven
portion of the debt. For this reason, many financial writers and
debt counselors are strongly critical of debt settlement, to the
point where they actually recommend against it just because you
might end up owing taxes. But the tax consequences of settling
your debts are greatly over-emphasized, and this is a really
just a minor issue at best.
First, even if you end up owing taxes on the canceled balances,
that's because you saved a bunch of money off your original
debts. The total of what you paid the creditor, plus the taxes,
will still be much less than what you owed to begin with. There
is still a net savings. So it's hard to understand why this is
viewed as a problem in the first place!
Second, the great majority of people who settle their debts are
not required to pay taxes on the forgiven part of the balance.
That's because of the "insolvency" rule, described in IRS
Publication 908, "Bankruptcy Tax Guide." Don't let the title
fool you. You don't need to have filed a formal declaration of
bankruptcy to take advantage of the insolvency rule.
Basically, "insolvent" means that you have a negative net worth
-- that is, you "owe" more than you "own." As a consequence,
most debtors do not have a tax liability on the canceled debts,
simply because most debtors are insolvent! It usually comes down
to home equity. If you have enough equity in a home (or other
property) to outweigh the total of your liabilities (debts),
then you have a positive net worth, and will likely have to pay
taxes on the forgiven debt amounts. However, the majority of
people in serious debt trouble have a negative net worth, and
are therefore insolvent. The way it works is that you can offset
the canceled debt up to the amount by which you were insolvent
at the time you did the settlement.
Come tax time, be sure to get professional tax advice specific
to your situation. Also, be sure to read the section in IRS
Publication 908 on "reduction of tax attributes," which requires
people using the insolvency rule to reduce their basis in such
things as rental property, loss carryovers, etc. Most of that
probably won't apply to you, but again, get specific advice
before winging it.
So, the message is, relax about paying taxes on canceled debt
balances. That should be the least of your concerns if you're
upside down financially. Don't let the misguided criticisms of
financial writers (who haven't done their homework) discourage
you from looking into one of the most popular and flexible
options for achieving debt-freedom.