Tax Consequences of Settled Credit Card and Other Debt

Dealing with debt can be super stressful. Between annoying collectors calling all hours of the day, and that ever-growing interest, it can feel totally impossible to get out from under it all. If you’re struggling with high credit card balances or other debts, debt settlement may seem like an attractive option to finally find some relief. But before you go that route, it’s really important to understand that there can be tax consequences when you settle debt for less than you owe.

The IRS sees that canceled or forgiven debt as taxable income, so you could end up with a surprisingly high tax bill if you’re not prepared. In this article, we’ll break down how debt settlement works, when you will or won’t owe taxes on settled debts, and how to handle the tax implications. Let’s dig in!

How Does Debt Settlement Work?

With debt settlement, you work with a debt settlement company to negotiate down your total owed balances. The company contacts your creditors and tries to get them to agree to let you pay a smaller amount (usually 30-50% less) and consider the rest of the debt settled. This can take months of back-and-forth, but the end result is you pay way less than you originally owed.

You can also try to negotiate debt settlements yourself without using a debt settlement company. Your creditor may agree to reduce the amount owed to avoid sending the debt to collections. Just keep in mind that debt settlement can hurt your credit score since it will show up on your credit report.

The Tax Implications of Settled Debt

Now, here’s where things get tricky. Let’s say you owed $10,000 on a credit card, but through debt settlement were able to get the creditor to accept $4,000 as payment in full. That’s $6,000 in debt that got canceled or forgiven. The IRS sees that $6,000 as taxable income, even though you didn’t actually receive any cash.

So if your creditor cancels or forgives $600 or more in debt through a settlement, they are required to report it to the IRS on Form 1099-C. And you are required to report that canceled debt amount as “other income” on your tax return.

The tax rate you’ll pay depends on your total income and tax bracket. For example, if you’re a single filer with $50,000 in income, including the $6,000 of canceled debt, you would fall into the 22% bracket. So you would owe $1,320 ($6,000 x 22%) in taxes on that settled debt amount.

Obviously, that extra tax bill takes away some of the benefit of settling your debt for less. But in most cases, you’re still coming out ahead compared to paying the full balance. Just be sure you set aside money to cover the taxes so you don’t get caught off guard.

When You Don’t Owe Taxes on Settled Debt

There are some exceptions where you may not have to pay taxes on forgiven debt from a settlement:

• Student loan debt forgiven through certain federal student loan forgiveness or discharge programs
• Debt canceled in bankruptcy
• Debt canceled when you are insolvent (your liabilities exceed your assets)
• Debt forgiven on your primary residence in a foreclosure
• Debt canceled by an identity thief

So if you can prove insolvency or bankruptcy, you may be off the hook for taxes on settled debt. For insolvency, the amount of debt forgiven that you can exclude is limited to the amount by which you were insolvent. You would still pay taxes on any forgiven debt above that threshold.

For example, let’s say you have $90,000 in assets and $150,000 in credit card debt. Your liabilities exceed your assets by $60,000, so you are insolvent by $60,000. If $100,000 of your debt is forgiven through settlement, only $60,000 of that canceled debt could be excluded from taxes. You would still need to pay income taxes on the other $40,000.

Other Potential Tax Implications

If you receive a 1099-C tax form from a creditor for canceled debt, be aware that it may impact your ability to deduct certain expenses on your tax return.

For example, you generally can’t claim a home mortgage interest deduction if the underlying mortgage debt was forgiven. And you can’t deduct legal fees related to a debt cancellation. So be sure to consult a tax pro if you receive a 1099-C.

Strategies for Handling Debt Settlement Taxes

Now that you know settled debt can leave you with a tax bill, here are some smart strategies to make sure you’re prepared:

• Save for the tax hit – Estimate the amount of tax you’ll owe on any canceled debt and set aside money to cover it.
• Negotiate with the tax debt in mind – When negotiating a settlement, consider the tax implications. Aim for the highest reduction possible to make the extra taxes worthwhile.
• Explore exceptions – If you’re insolvent or qualify for an exception, provide documentation to your creditor to avoid getting a 1099-C.
• Talk to a tax pro – Consult a tax professional to understand the tax impact and make sure your returns are handled properly.
• Consider the timing – If possible, strategically time debt forgiveness to occur in a year when you have lower income and a lower tax rate.
• Pay estimated taxes – Make quarterly estimated tax payments on canceled debt to avoid a big bill at tax time.

The Bottom Line

Debt settlement can seem like a lifeline when you’re drowning in high-interest credit card balances. But before pursuing settlement offers, be sure you understand the process and tax implications involved. With smart planning, you can reduce your debt burden without getting slammed with a surprise tax bill.

And hey, if you need help getting your finances on track, there are tons of great credit counseling agencies out there that offer free advice. They can help you budget, negotiate with creditors, and find the debt relief option that works best for your situation. Don’t be afraid to ask for help – it’s the first step to getting back on solid financial ground. You’ve got this!