If you’re overwhelmed by aggressive collection calls, you may consider settling your debt for less than you owe. This is a good option for people in over their heads, but it doesn’t come without its difficulties. Read on to find out what debt settlement means for your taxes.
What is debt settlement?
Debt settlement is an agreement between the creditor and the borrower. Both parties agree on a reduced amount to pay off the debt in full. The borrower gets the advantage of paying a smaller amount than he owes, and the creditor gets a partial payment instead of having to write off the entire balance.
Of course, debt settlement doesn’t come without its costs to the borrower. Debt settlement will appear on your credit report as such and hurt your credit score. Also, you may have to pay taxes on the difference between what you paid and what you owed. Yes, the amount of debt you didn’t pay is generally reported to the IRS as income.
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While settling your debt may be a huge relief, you need to be prepared to pay taxes on the amount settled. Depending on the type of debt, your creditor may send you a 1099-C cancellation of debt tax notice. This information will be reported to the IRS, and you'll need to report it as "other income" on your tax return. One exception is for student loan debt forgiveness: The American Rescue Plan that President Biden signed into law in March 2021 exempts student loans forgiven through December 2025 from being considered gross income.
While you might be left on the hook paying taxes, you have a few options for tax relief if that's the case.
Even if you don’t receive a 1099-C, you may still be legally required to report canceled debt as income. As with anything else, there are exceptions; you can find the exceptions and more information on IRS Publication 4681.
How much do I have to pay?
This income is taxed at your normal tax rate, which can range from 10% to 37%, based on your taxable income. The United States has a progressive tax rate, meaning that the tax percentage increases as the taxable base increases.
What if I choose not to report it?
Legally, you must report all taxable income received — and this includes your debt settlement amount. If a 1099-C is issued to you, the IRS is also receiving a notice of income, and you can be penalized for not reporting. You’ll have to pay not only the tax you owe, but also fines.
If you don’t receive a 1099-C, the IRS won’t receive this information either. However, if you’re chosen for an audit for any reason, this will likely be discovered. Stay on the right side of the law and report all income. It isn’t worth it to break the law and underreport. If you need additional guidance, it’s best to speak with a tax professional who can help you determine the best course of action.
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While settling your debt may be a huge relief, you need to be prepared to pay taxes on the amount settled. Depending on the type of debt, your creditor may send you a 1099-C cancellation of debt tax notice. This information will be reported to the IRS, and you'll need to report it as "other income" on your tax return.
You should expect to pay the same income tax rate for settled debt as you pay on your income. For example, if you're in the 22% income tax bracket and have $600 worth of canceled debt, the tax bill would come out to $132 ($600 x 0.22).
Settlement money and damages collected from a lawsuit are considered income, which means the IRS will generally consider that money taxable. However, personal injury settlements are an exception (most notably: car accident settlements and slip and fall settlements are nontaxable).
"The biggest benefit of debt settlement is that it can significantly reduce the total amount of debt you owe," says Leslie Tayne, a financial attorney and author of Life & Debt.
In general, if your debt is canceled, forgiven, or discharged for less than the amount owed, the amount of the canceled debt is taxable. If taxable, you must report the canceled debt on your tax return for the year in which the cancellation occurred.
In most situations, if you receive a Form 1099-C from a lender, you'll have to report the amount of cancelled debt on your tax return as taxable income. Certain exceptions do apply.
Section 104 excludes settlement money received for personal physical injuries and physical sickness. This means that money from the settlement for medical costs, lost wages, pain and suffering, and other losses from physical harm do not need to be reported as income.
The general rule regarding taxability of amounts received from settlement of lawsuits and other legal remedies is Internal Revenue Code (IRC) Section 61. This section states all income is taxable from whatever source derived, unless exempted by another section of the code.
The party that pays a taxable settlement or judgment to the injured party and/or their attorney will issue a Form 1099-MISC, Form 1099-NEC, or W-2 to report the settlement. In some cases, the claimant and attorney are issued separate 1099s reporting the same settlement dollars.
Cons. Credit score impact: Debt settlement can negatively impact your credit score, as settled accounts may be reported as “settled” or “charged-off.” A debt settlement may remain on your credit report for up to seven years. Creditor cooperation: Typically, lenders are unwilling to settle current debts.
The balance owed is reduced, sometimes by as much as 50% It's a way to avoid bankruptcy for those who can pay the settlement amount. Once the debt is paid off, debt collectors or collection agencies will stop calling.
After you settle debt, the amount you don't pay will be charged off by the creditor or collector. Charge-offs will stay on your credit for seven years.
How Long After a Debt Settlement Can You Buy a House? There's no set timeline for how long it takes to get a mortgage after debt settlement. Your ability to qualify for a mortgage will depend on how well you meet the lender's requirements on the issues raised above (credit score, DTI, employment and down payment).
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.
Is it better to settle debt or pay in full? Paying debt in full is almost always the better option when possible. Research debt payment strategies — debt consolidation could be a good option — and consider getting financial counseling.
The general rule regarding taxability of amounts received from settlement of lawsuits and other legal remedies is Internal Revenue Code (IRC) Section 61. This section states all income is taxable from whatever source derived, unless exempted by another section of the code.
Legal settlements that are taxable (including previously deducted medical expenses related to physical injury or illness) are entered as miscellaneous (other) income. Interest earned on settlements is taxable income and should be entered as a Form 1099-INT.
Paying a debt in full is better than settling a debt
You'll also save money. Settling the debt eliminates future interest and reduces the amount you'll repay to the lender. When you settle a debt, the creditor or debt collector will typically report the account as settled for less than what you owed.
Introduction: My name is Dan Stracke, I am a homely, gleaming, glamorous, inquisitive, homely, gorgeous, light person who loves writing and wants to share my knowledge and understanding with you.
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