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Debt settlement sounds like an attractive solution to a serious financial problem, but in addition to being difficult to negotiate, debt settlement often comes with another complication — taxes. All the money you no longer have to pay to creditors? The Internal Revenue Service may consider income and want you to pay taxes on it.
What Is Debt Settlement?
Debt settlement is an agreement in which creditors accept less money than you owe them. It’s something you can do by yourself or pay a reputable debt settlement company to negotiate with your creditors for you.
The process involves offering a lump-sum payoff that’s lower than the amount you owe and finding a reason for the creditor to say yes to less money. The win for creditors is usually that they can close your file after getting money from you that, in their eyes, they might not get in the long-term.
Your win, of course, is that you reduce your debt burden.
But debt settlement also has a few drawbacks and risks.
When you turn to debt settlement, you admit you couldn’t meet your initial financial obligations. This is something that will appear on your credit report as a negative for seven years, and it will hurt your credit score. That, in turn, will limit you financially.
You also may owe extra late fees and interest charges while you build the “lump-sum” amount necessary to settle your debt. There is also no guarantee that your creditors will accept your settlement offer. They’re under no obligation to negotiate with you or anyone.
Even if they say yes, you may owe taxes on the amount of debt that your creditors cancel. The Internal Revenue Service considers this forgiven debt as taxable income.
As you weigh the pros and cons of debt settlement, consult a financial advisor or a credit counselor to understand all the ramifications of how debt settlement will affect you.
Do You Have to Report Settled Debts?
After you settle a debt of $600 or more, your former creditor — or a debt collector — is likely to send you a form 1099-C the January after your settlement closes. The 1099-C tax form reports the amount of debt it cancelled or forgave. You’re required to report it as other income.
Even if you don’t receive a 1099-C, you’re still required to report the amount of your forgiven debt on your tax return. There are exemptions, which include the student loan debt forgiveness plan under the 2021 American Rescue Plan that exempts forgiven student loans through 2025 from being considered gross income.
You can find more information about exemptions from IRS Publication 4681.
Debt Settlement Tax Consequences
Depending on the rest of your financial status, when you have a settled debt for less than the full amount owed, you may owe taxes on the money that was forgiven.
The IRS considers any debt cancelation of $600 or more as additional income — and taxable — even if you didn’t actually receive any money. Each Form 1099-C shows the amount of your debt canceled by a specific former creditor and when. The IRS gets a copy of your 1099-C to verify your income.
How Are Taxes for Debt Settlement Calculated?
How much will you owe in taxes from your debt settlement? That depends on your overall taxable income. Your income, including amounts listed on your 1099-Cs, gets taxed at the normal progressive rate, which ranges from 10% to 37%.
How much tax you will owe depends on your tax bracket, filing status, credits, and deductions. If you have a lot of deductions, you may be able to reduce your taxable income —and the amount you owe on forgiven debt.
It’s important to note that, given the progressive tax rate, additional reported income from your forgiven debt could push you into a higher tax bracket, resulting in a larger tax bill. You may be able to reduce or eliminate the tax liability by claiming an exclusion or exception, such as insolvency, bankruptcy, or qualified principal residence indebtedness.
Failure to report your forgiven debt could attract an IRS audit and future tax penalties and interest charges.
Tax Exemptions for Canceled Debts
The IRS allows some exceptions and exclusions to paying taxes on your debt settlement income. In some cases, you won’t owe taxes on your canceled debt. According to the IRS, here are a few examples when you don’t have to report and pay taxes on forgiven or canceled debt:
- If your debt was canceled as part of a Chapter 7, Chapter 11or Chapter 13 bankruptcy. You usually don’t have to pay taxes on your canceled debt, although you may have to reduce some of your tax credits by the amount of the canceled debt.
- If the debt was canceledas a gift, inheritance, or bequest.
- If the debt was forgiven as part of a student loan forgiveness program, such as the American Rescue Plan. Signed in 2021 by President Biden, the law exempts student loans forgiven through December 2025 from being considered gross income.
- If the debt canceled was a student loan for someone who works for a certain duration for a certain class of employers.
- If the debt canceled came from other educational loan forgiveness programs for providing health services in certain areas.
- If the discharged amount was from certain federal, private, or educational student loans.
- If you can demonstrate that you were insolvent at the time your debts were canceled.
- If the canceled debt was less than $600.
- If the canceled debt would have been a deductible item for the borrower.
- If the canceled dent was from a non-recourse loan (typically used in real estate transactions).
- If you were a qualified farmer and the canceled debt came directly from your farming business.
If you qualify for an exception or exclusion, you don’t need to report your canceled debt on your tax return.
Alternatives to Debt Settlement
Debt settlement offers a compelling solution for discharging your debts fast. But it can have negative consequences: damaging your credit score, increasing your tax liability, and exposing you to high charges and fees.
Fortunately, alternatives exist that may be easier for you and your financial future. Alternatives to debt settlement include:
- Bankruptcy:This legal process eliminates or restructures your debts under court protection. The IRS doesn’t usually tax debts discharged through bankruptcy. And you may be able to retain your assets and repay some creditors over time depending on your bankruptcy. Although this approach gives you a fresh start, it affects your credit score for up to 10 years.
- Credit Counseling:This service lets you to work with a certified credit counselor to create a budget and enroll in a debt management plan. It can get you lower interest rates and fees on your debt — and doesn’t affect your credit score or tax situation — but it also doesn’t reduce the principal balance. A credit counseling session can also help you learn how to better manage your finances and improve your credit score.
- Debt Consolidation Loan: This process combines multiple debts into one debt consolidation loan with manageable terms, a lower interest and a specific (and often longer) repayment term. Although you can lower your monthly payments and lower your interest fees, it doesn’t lower the amount of your debt. Debt consolidation can damage your credit score temporarily, but it doesn’t increase your tax burden.
If you choose to pursue any of these approaches, it is important to make sure that you work with a reputable company or organization.
Speak to a Credit Counselor About Debt Relief
Each alternative plan has pros and cons. If you’re torn between debt settlement vs. credit counseling or wondering whether debt consolidation or debt settlement will work best for you, talk to a credit counselor or financial advisor.
A certified credit counselor can help you assess your overall financial situation, create a realistic budget and work with your creditors. A counselor can also enroll you in a debt management program to pay off your debts, in full, with lower interest rates and fees.
Credit counseling is a valuable service that can help you get out of debt and stay out of debt. By speaking to a credit counselor, you can learn how to manage your money better, avoid falling into debt traps and achieve your financial goals.
Credit counseling is usually free or low-cost, and you can do it online or over the phone. Choose a reputable credit counselor certified by the National Foundation for Credit Counseling (NFCC).
