Do You Have to Pay Taxes on Your Debt Settlement?

After deciding to get your finances back on track through debt consolidation, you were successful in convincing your creditors to accept lesser amounts to settle your outstanding debt. By paying them off and closing the accounts, you effectively shut the door on anything having to do with those bills forever. Or so you thought.

From the Ashes

Fast-forward to next January. In the mail you receive a succession of 1099 forms, all from the aforementioned creditors, now claiming to have provided you with income during the previous year. What gives? The answer to that question can be spelled out with three letters: IRS. As it does lottery winnings and cars won in raffles, the Internal Revenue Service considers forgiven debt of $600 or more to be income, even if it was part of a debt consolidation plan. It’s called discharge of indebtedness income. While that might not seem fair on its surface, remember: income, by definition, is money you receive that you don’t have to pay back. And all income is subject to taxation.

A word of warning: this isn’t one of those cases in which the government casts a financial fishing net, content with whatever happens to become ensnared in its mesh. The IRS takes discharge of indebtedness income every bit as seriously as it does employment wages, and it will expect you to do your part as a U.S. citizen and pay taxes on it. Even if a creditor fails to live up to its obligation and doesn’t send you a 1099 form, you won’t be excused from paying taxes on the forgiven debt. Odds are the creditor has reported its role in your debt consolidation to the IRS, which will be expecting its money either way.

Pinpointing a Loophole

However, there is an exception to every rule, and this rule’s no different. Taxpayers who were considered insolvent when the debt consolidation action occurred are excused from paying discharge of indebtedness tax. In other words, if the amount of your debt exceeded the amount of your assets when the debt was forgiven, you’re in the clear. That’s not to say you can simply ignore the issue when it’s time to file your taxes. As previously mentioned, the IRS will likely know about your forgiven debt, so if you don’t address it you’ll be considered liable. You’ll need to submit form 982 along with the rest of your tax paperwork, and you should be prepared to prove insolvency if the claim is questioned.

A Good Deal Either Way

If you don’t think you’ll qualify for insolvency, don’t be too quick to write off debt consolidation as a potential solution to your financial problems. In most cases, you’ll still come out ahead even after giving Uncle Sam a cut of the money you saved. For example, if a creditor agrees to accept $1,000 to settle an account with a $2,000 balance, and then the government steps in and asks for 15 percent of the $1,000 you “received,” you’ve still saved $850. Even if you think you might be teetering on the edge of a higher tax bracket, only in the very rarest of circumstances will your discharged debt end up causing more harm than good. Nevertheless, it would probably be wise to consult with a tax professional before entering a deal with your creditors.

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