What Settling a Debt Can Mean at Tax Time

It almost seems too easy. Settle your debt, the TV ad goes, for 'pennies on the dollar'. It isn't bankruptcy, so you're not looking at 7 years of bad luck. What the ads don't tell you, though, is that a settlement will show up on your credit report, possibly bringing your credit score down.

However, there's another issue to be aware of when considering a debt settlement. As far as the IRS is concerned, anytime you've been forgiven for more than $600 of debt, the money you no longer owe is considered income.

And income is, of course, taxable.

So, say you have $20,000 worth of debt. You're able to negotiate with the creditor for a payment of $8,000 instead of the full amount and wipe the debt clean.

Sweet.

Except now there's a mark on your credit report. And you also owe taxes for $12,000 worth of income.

How will the IRS know? Well, the creditor will provide you with a 1099-C tax form. So, it's official, and you owe taxes on the forgiven debt because you borrowed the money at one point and didn't repay it. Looking at it from the IRS's perspective, you've just earned money. And, yeah, the IRS wants a slice.

But there are exceptions. When your debts are greater than your assets (for example, you owe $50,000 and your assets are $30,000), the IRS will usually waive the tax liability for any forgiven debt that makes up the difference. In this case, if your debts are $20,000 more than your assets, you can show "income" of up to $20,000 through a debt settlement without having to worry about paying taxes on the money you didn't repay. Just make sure you file Form 982 with your taxes in the year that you received a debt settlement.

Before agreeing to a settlement, or actively looking for one, speak to your tax advisor and find out how it'll effect you in the long run.