Editor’s note: Please be aware that we’re not tax professionals and this is not tax advice, just a general guideline.
When making minimum debt payments becomes overwhelming, some people turn to debt settlement as a way to handle it. Working with a debt settlement company can come with many drawbacks including high fees, a major hit to your credit score, and eventually, a higher tax bill. This last one can come as an especially unwelcome surprise after you feel that everything has been settled. Here is what you need to know about paying taxes on your debt settlement:
Do I have to pay taxes on settled debt?
The IRS considers most types of settled, forgiven, canceled, or discharged debt as taxable income. This means that in general, yes, you need to pay taxes on it. When your debt is settled, your creditor will likely send you a Form 1099-C reporting the amount of your original debt that you did not pay through settlement. For example, if you settled a $20,000 debt for $9,000, you would have $11,000 of potentially taxable income reported on your 1099-C.
How can I avoid paying taxes on settled debt?
There are two main exceptions to the taxation of canceled consumer debt:
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Chapter 11 Bankruptcy: If your debt was discharged through Chapter 11 bankruptcy, you do not need to pay taxes on the amount of canceled debt.
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Insolvency: If your liabilities exceeded your assets at the time of the debt cancellation, you also qualify for an exemption from paying taxes on the forgiven amounts. Although it’s not required, you should consider filling out and keeping a copy of the IRS’s insolvency worksheet from Publication 4681 along with supporting documents in case the IRS ever questions your calculations
In both cases, you need to file Form 982 with your tax return.
Does this apply to student loans?
In general, yes, but there are several exceptions including:
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Public Service Loan Forgiveness (PSLF): Student loan debt forgiven through PSLF is not taxed at the federal level.
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Income-Based Repayment: After paying on your student loans for 20-25 years through an income-based repayment plan, the remainder of your balance is forgiven. Currently, if that cancellation happens between 2021 and 2025, it is not taxable at the federal level.
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$10,000 Federal Student Loan Cancellation: If the Biden administration’s $10,000 of student loan forgiveness successfully makes it out of the courts intact, it will not be taxed at the federal level.
What if I don’t receive a Form 1099-C for my settled debt?
Just like with other forms of income, you are responsible for accurately reporting your income to the IRS whether you received a tax form for it or not. This is also true of settled, forgiven, or discharged debt.
Final Thoughts
The fact that settled, discharged, or forgiven debt is often taxable shouldn’t necessarily prevent you from pursuing that path, but it should factor into your decision-making. You should also prepare for it by either saving some extra cash before tax time or keeping your documents in order to prove that qualify for an exemption.
