While paying off your debt may be a big relief, you should be aware that you will have to pay taxes on the amount paid. Your creditor may issue you a 1099-C cancellation of debt tax notice, depending on the type of debt. This information will be reported to the IRS, and you’ll need to include it in your tax return as “other income.” One exemption is debt remission for student loans: President Biden signed the American Rescue Plan into law in March 2021, exempting forgiven student loans from being counted as gross income until December 2025.
Do you have to pay taxes on settled debt?
A debt settlement does require you to pay taxes. Because the IRS considers the percentage of your debt forgiven following a debt settlement to be income, you will be taxed on it. Forgiven debt (also known as canceled debt) is taxed at your federal income tax bracket rate.
Your creditor will send you and the IRS a Form 1099-C declaring your forgiven debt if you have $600 or more in forgiven debt. Whether or not you receive a 1099-C, you must report your forgiven debt as income. The IRS will compare what your creditor reports as forgiven debt to your tax return and send you a warning if you don’t mention it.
The reporting requirement has two key exceptions. The first is insolvency, which occurs when your liabilities exceed your assets. Debts erased through bankruptcy are another exception.
If you were insolvent before your debt was settled, you simply have to declare the percentage of forgiven debt that exceeds your net worth.
As an example, suppose you have $20,000 in assets and $30,000 in debts for the year 2021. This indicates that you have a net worth of $10,000.
You had $15,000 in debt canceled over the year. This means you owe $5,000 in debt that has been forgiven. This is recorded on Schedule 1, line 8, and then on Line 7a of Form 1040. Form 982, line 2, is used to declare the remaining $10,000 in forgiven debt.
Exception 2 – Bankruptcy: You do not have to record your settled debt as taxable income if it was canceled in a bankruptcy proceeding. However, you must declare it on Form 982 to prove that your debt has been erased.
The forgiven part of debt that results from the debt settlement process is taxed by the IRS. This portion is recorded on Form 1040, line 7a, and is taxed at your federal income tax rate.
A creditor will send you a 1099-C if you owe them $600 or more in forgiven debt. Even if you don’t get a 1099-C, you should always record forgiven debt as income. The IRS will send you a notice if you don’t report it.
How will debt settlement affect my taxes?
You may be taxed on any forgiven debt over $600 if you are able to reach a settlement that is much less than your total obligations outstanding.
“The creditor must file a 1099-C form with the IRS detailing the amount of your resolved debt,” Tayne explains. You will also receive a copy of the 1099-C forgiveness of debt form from the forgiving creditor in the tax year in which the last payment is made, similar to income tax forms.
“That paperwork will tell you the amount forgiven,” Tayne explains, referring to the amount that isn’t taxable income. On your tax forms, there is a designated line for this reason.
This rule has some exceptions and exclusions, which are listed below. Tayne contends that even if you do end up paying taxes on your forgiven debt, “you’ll generally be better off than if you had to pay the full sum.”
Does cancellation of debt affect your taxes?
You have a debt if you borrow money and are legally required to repay a definite or determinable sum at a later period. You could be personally liable for a debt or possess property that is encumbered by one.
Your debt is considered canceled in the amount that you don’t have to pay if it is forgiven or discharged for less than the entire amount you owe. However, there are a few exceptions to the rule, in which the amount you don’t have to pay isn’t considered canceled debt. These exceptions will be covered in greater detail later. A debt may be cancelled if the creditor is unable to collect, or has given up trying to collect, the amount you owe. A foreclosure, repossession, voluntary transfer of the property to the lender, abandonment of the property, or a mortgage modification may result in the debt being cancelled if you own property subject to a debt.
In general, if you have cancellation of debt income because your debt is canceled, forgiven, or discharged for less than the amount you owe, the canceled debt is taxable, and you must record it on your tax return for the year it occurred. If the law specifically enables you to deduct it from gross income, the canceled debt isn’t taxed. These exclusions will be explained in more detail later.
After a debt is canceled, the creditor may give you a Form 1099-C, Cancellation of Debt, which includes information such as the amount of the debt cancellation and the date of cancellation. If the information on your Form 1099-C is erroneous, contact the creditor to get it corrected. For example, if the creditor is still attempting to collect the debt after mailing you a Form 1099-C, the debt may not have been canceled, and you may not have income from a canceled debt. You should confirm your individual situation with the creditor. Whether or not you receive a valid Form 1099-C, it is still your duty to declare the taxable amount of canceled debt as income on your tax return for the year in which the cancellation occurs.
If the debt is a nonbusiness debt, you must report any taxable amount as ordinary income from the cancellation of the debt on Form 1040, U.S. Individual Income Tax Return, Form 1040-SR, U.S. Tax Return for Seniors, or Form 1040-NR, U.S. Nonresident Alien Income Tax Return as “other income” on Form 1040, U.S. Individual Income Tax Return, or Form 1040-NR, U.S. Nonresident Alien Income Tax Return, or Canceled Debts, Foreclosures, Repossessions, and Abandonments, Publication 4681 (for Individuals).
Caution: If you have property that secured your obligation and the creditor takes it in full or partial payment of your debt, you are considered to have sold it to the creditor. If you were personally liable for the debt (recourse debt) or not personally liable for the debt (non-recourse debt), your tax treatment will differ (nonrecourse debt).
The amount realized if your property was subject to a recourse debt is the property’s fair market value (FMV). The amount of the debt in excess of the FMV of the property that the lender forgives is your usual income from the debt cancellation. Unless you meet one of the exceptions or exclusions listed below, you must include the debt cancellation in your income. Gain or loss on the sale of the property will be the difference between the FMV and your adjusted basis (typically your cost).
If your property was subject to a nonrecourse loan, the total amount realized is the nonrecourse debt plus any cash and the FMV of any property you received. You will not receive regular income as a result of debt discharge.
The examples below demonstrate the distinction between recourse and nonrecourse debt.
- You paid $2,000 down and signed a $18,000 recourse note on a $20,000 boat for business use. You are no longer able to make payments on the note after paying down $4,000 on it. The boat was repossessed by the boat dealer, and it is now worth $11,000. You will receive $3,000 in regular income from the debt cancellation ($14,000 outstanding debt owed less $11,000 FMV of boat). The difference between the boat’s FMV of $11,000 (the amount you realized on repossession) and $20,000 will result in a $9,000 loss on disposition (your adjusted basis in the boat).
- The only difference is that when you bought the yacht, you signed a nonrecourse note. When the dealer repossesses the boat, you will lose $6,000, which is the difference between the $14,000 realized (the face amount of the remaining debt) and the $20,000 you paid for it (your adjusted basis in the boat). You have no regular income as a result of the debt elimination.
For further information on canceled debt and reporting gain or loss from repossession, foreclosure, or abandonment of property, see Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals). Publication 544, Asset Sales and Other Dispositions, and Publication 523, Selling Your Home, are also helpful.
Amounts that meet the criteria for any of the following exceptions are not considered debt cancellation income.
Is it worth it to settle debt?
It is usually preferable to pay off your debt completely if at all possible. While paying off an account may not hurt your credit as much as not paying at all, having a “settled” status on your credit report is still a bad thing.
When you settle a debt, it indicates you’ve worked out a deal with the lender and they’ve agreed to accept less than the whole amount owed as the account’s last payment. The account will be marked as “settled” or “account paid in full for less than the full sum” by the credit bureaus.
How do I avoid paying taxes on a 1099 C?
Form 1099 is a statement of information. It is sent out on a regular basis and without much thinking on the part of the creditor.
When real estate is transferred or a debt is forgiven, the creditor is obligated to notify the transaction to the Internal Revenue Service.
You, as a potentially impacted taxpayer, will receive a copy.
Claim the exceptions to the rule
The Internal Revenue Code begins with the premise that forgiven debts improve your net worth. There must be a tax payable, according to IRS logic.
If you qualify for one of these exclusions, the forgiven debt will not be added to your taxable income.
You must complete IRS Form 982 to substantiate your entitlement to exclude the money stated on the 1099.
If you don’t file the form and claim the exception, the IRS will have no means of knowing that there is no tax due despite the debt forgiveness.
Form 982 tax-avoiding choices
Bankruptcy–In bankruptcy, the debt is forgiven without any tax penalties. On Form 982, it’s the first exception. Title 11 of the United States Code contains bankruptcy laws. The tax exemption applies to debt discharges in any bankruptcy chapter.
Insolvency–Perhaps you owed more to other creditors than the worth of your assets when the debt in question was forgiven.
The forgiven debt isn’t required to be included in your income.
You were bankrupt.
However, keep in mind that the value of retirement assets that your creditors can’t get is factored into the solvency assessment.
When you factor in pensions, etc., many people who have little net worth outside of retirement funds are actually solvent.
With the Great Recession and a rash of foreclosures, Congress provided a temporary safe harbor for debt forgiven on a primary property.
The loan has to be utilized to purchase or upgrade the home.
The law was recently extended to cover the 2016 tax year.
In case of mistake
Another instance in which you can receive a 1099 but not owing tax is if you had no personal culpability for the debt forgiven; that is, the debt was a non recourse debt. The foreclosure agent is unlikely to know whether the lender had the legal authority to suit you.
If none of the other exceptions to including income apply, think about whether you were personally liable for the debt.
If not, request a correction to the 1099 or provide an explanation with your tax return detailing the facts of your situation.
Does settling with the IRS hurt your credit?
If you owe taxes, you must make preparations to pay them. Here are various choices for paying your taxes, as well as how they may affect your credit.
Payment Option 1: Installment Agreements
Despite its bad reputation, the IRS recognizes the difficulties that consumers face and offers debt settlement and tax relief options. It has no effect on your credit if you agree to pay a tax bill through an installment plan with the IRS. The IRS does not report installment arrangements to credit reporting organizations. For taxpayers who are unable to pay their taxes in full, the IRS offers a variety of payment options, including online payment agreements.
Is debt forgiveness considered income?
You may owe income taxes on the amount of debt forgiven, wiped out, or negotiated away last year if you had debt forgiven, wiped out, or negotiated away.
Debt relief, including forgiven credit card debt, is considered taxable income in the majority of circumstances, according to Logan Allec, a certified public accountant in Santa Clarita, California.
“We have an acronym for that in the tax world: COD income,” Allec explained. “It stands for ‘debt elimination.'”
Can I get my money back from a debt settlement company?
Many clients who have entered into a contract with a debt settlement company come to us looking to file bankruptcy. Many people believe that by signing up with a debt settlement firm, they will be able to get out of debt with little or no affect on their credit score. Many people believe that debt settlement won’t harm their credit as much as bankruptcy would. This is untrue. Credit card issuers won’t even consider negotiating bills unless you’ve been in default for at least 90 days. Debt settlement firms promise to negotiate debts in exchange for a lump-sum payment at a fraction of the cost. They fail to inform customers, however, that as their accounts become late, the consequences for their credit score might be severe. Debt settlement might take anywhere between 36 and 48 months. This is the third year in a row that accounts have been late. Interest, fees, and penalties continue to accrue throughout this time. Most consumers are unable to afford these payments and, as a result, never complete a debt settlement plan.
Debt settlement businesses, moreover, neglect to advise customers about the dangers of being late on their credit cards. Creditors can sue and obtain a judgment if a credit card remains unpaid for a lengthy time. A judgment can last up to 20 years, and creditors can garnish wages, seize property, and freeze bank accounts as a result of it.
The Federal Trade Commission (FTC), which safeguards consumers, has created regulations governing debt settlement companies. They’ve passed legislation prohibiting debt settlement organizations from engaging in fraudulent telemarketing practices. Before you sign up for debt settlement, debt settlement agencies are obligated by law to tell you a list of items. The following are some of the obligations that debt settlement businesses must disclose to you:
- You have the right to cancel the debt settlement agreement at any time and without penalty.
- Unless the money were earned by the debt settlement company, all funds placed in escrow account are your funds and you are entitled to them.
How do I pay off my debt to the IRS?
You owe more than the indicated amount when you owe tax debt. On the amount owed, the IRS will assess penalties and interest. As a result, the debt becomes more greater and more difficult to repay. Under certain circumstances, though, you may be able to reduce penalties and interest. You can request a complete or partial waiver of the penalties, resulting in a lesser overall balance due. If the IRS declines your request to have penalties removed from your account, you can file a formal appeal. The key to dealing with fines and interest is to deal with them as soon as possible before they build further.
What to do if you get a 1099-C for an old debt?
Receiving a 1099-C should always indicate that the debt has been canceled and is no longer being pursued. However, it may be up to you to verify.
Until 2016, IRS regulations enabled creditors to file a 1099-C if they had not received payment on a debt for 36 months. As a result, a large number of 1099-C forms were produced for debts that were past due but not yet forgiven. In its yearly reports to Congress, the IRS Taxpayer Advocate Service listed the resulting misunderstanding as a top priority for the agency to resolve.
Due to an IRS regulation change that took effect in November 2016, creditors are no longer required to issue a 1099-C form simply because a debt has been unpaid for 36 months.
If you receive a 1099-C for a debt you didn’t realize was discharged, contact the creditor to inquire about the status of the bill. Request that they retract the 1099-C in accordance with Internal Revenue Bulletin 2016-48, T.D. 9793, if they are still following the previous regulation.
The IRS will be notified that the 1099-C was issued in error if it is revoked. If the creditor refuses to retract the form or certify that the obligation has been forgiven, you must follow the IRS dispute process detailed in Publication 4681 to demonstrate that no taxes are owing.
Can I buy a house during debt settlement?
While you can buy a house at any time, doing so during a debt settlement is a bad choice. Your credit is bad, and you don’t have a lot of money (otherwise, why are you settling?). While you’re in debt settlement, no reputable lender should provide you a mortgage loan. Anyone who does so will almost certainly make the conditions so harsh that you will be in much worse financial shape in the future.
How long after debt settlement can I buy?
It’s largely up to you. The sooner you improve your credit ratings and have enough discretionary income to cover a down payment and other costs, the sooner you’ll be able to buy a home.
Can you buy a house after debt consolidation?
If you consolidate your debts, you may be in a better position to qualify for a mortgage loan if you have fewer outstanding creditors. However, if your debt-to-income ratio (or late payment and default history) hasn’t changed significantly, a debt consolidation may not be very helpful in obtaining a mortgage.
How long does it take to recover from debt settlement?
This, like the question of when to buy, is entirely up to you. You’ll be able to state you’ve totally recovered from your debt settlement sooner if you enhance your financial profile as quickly as possible.
