When you've got bills stacked to the ceiling and no way to pay them all off, debt settlement can seem like a dream solution: You reach a deal with your creditors to pay what you can, and they forgive or cancel the rest. But that canceled amount doesn't just go poof. The Internal Revenue Service considers it income -- taxable income. And just like that, you've got another bill. Quite possibly a big one.
Why It's Taxable
People are sometimes astonished -- or outraged -- to learn that the government considers forgiven debt to be taxable income. But think about it. Debt is nothing more than money that someone gave you that you promised to pay back. When you don't pay it back, the description you just read gets shortened to "money that someone gave you." That's the definition of income, so of course it's taxable. The fact that you don't have the money anymore -- that it's been spent -- cuts no ice with the IRS.
Any amount of canceled debt is taxable income. If you had $10,000 in debt, for example, and you settled it for $2,000, then the $8,000 difference would be taxable. If you're in the 15 percent tax bracket, that could add as much as $1,200 to your tax bill. However, this rule generally applies only to principal -- the money or credit you actually received from the lender. Canceled interest charges, late fees or other penalties don't count. That's just what the lender is charging you for the use of its money; it's not money you ever received. So say you run up $10,000 in charges on your credit card. By the time you get to settlement, you also owe $5,000 in interest and $3,000 in late fees and penalties, for a total "debt" to the credit card company of $18,000. If you settle the debt for $4,000, then you have a taxable forgiven debt of $6,000 -- the $10,000 principal minus the $4,000 settlement. The additional $8,000 doesn't apply for tax purposes.
Whenever a financial institution, a government agency or any other business that regularly lends money cancels a debt of $600 or more, it must file Form 1099-C with the IRS. This form describes the nature of the debt and how much was canceled. The lender is also supposed to send a copy to the debtor. Lenders can, and do, send a 1099-C for canceled debts less than $600. But regardless of the amount of the canceled debt, and regardless of whether you actually get a 1099-C, you're responsible for paying taxes on your forgiven debt. There's a line on the standard federal tax return, Form 1040, labeled "Other income." This is where you enter the amount of forgiven debt.
There are a couple ways in which you may be able to get out of paying taxes on settled debt. One is if you can persuade your creditors to treat the debt forgiveness as a gift. Good luck with that one. The other is if you can demonstrate that you were financially insolvent before the debt settlement. That means the total amount of everything you owed, to everybody, was greater than the total value of all your assets. If you want to go this route, you'll need to file Form 982 with your tax return -- but more important, you'll need to consult a qualified tax professional. Getting in hot water with a creditor is one thing; getting in trouble with the IRS for improperly claiming insolvency can be jumping into a pot on full boil.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.