Turbo Takeaways
- The IRS requires individuals to report any money forgiven through debt settlement as income.
- Forgiven debt amounts over $600 require Form 1099-C as part of your tax return.
- Savings from settlement may not necessarily increase your tax bracket, but will be reflected on your tax bill.
Tax Implications of Debt Settlement
In many cases, yes, you will be responsible for paying taxes on settled debt. However, there are various nuanced reasons you may not end up owing anything to the IRS when your debt is forgiven through this debt relief option.
Debt settlement involves negotiating with creditors either on your own or through a debt relief company to cancel a portion of your debt in favor of a lump-sum payment on your balance. Since you no longer owe some of your balance once you settle a debt, the IRS counts that forgiven debt as taxable income.
Do You Have To Report Settled Debt to the IRS?
Yes, you need to report a cancellation of debt from settlement on your federal taxes. If your debt is forgiven, cancelled, or discharged for less than what you owe, the total amount you didn’t pay becomes part of your tax liability.
According to the IRS, “If taxable, you must report the cancelled debt on your tax return for the year in which the cancellation occurred.” Creditors will likely send you Form 1099-C after canceling $600 or more in debt. If not, you’ll still need to complete and submit the form yourself.
Even if you don't receive a form, any cancelled debt must be reported as income, unless it counts as an exception. Consider speaking with a tax professional to understand more about what you owe or if you're exempt.
If you settle more than one debt, you'll need to submit a form for each creditor who's forgiven your debts during the same tax year.
How Much Are You Taxed on Forgiven Debt?
Forgiven debt is taxed based on your income level. Your total income for the year dictates your tax bracket, which is anywhere from 10 to 37%. The forgiven amount is counted along with wages from your job and other revenue sources to create this amount.
For example, many consumers fall into the 22% tax bracket with incomes between $48,476 and $103,350. Below is a chart to show the possible tax consequences of settlement, including $5,000 in forgiven debt, with help from NerdWallet's Federal Income Tax Calculator.
| Tax Info | Outcome |
|---|---|
| Filing Status | Single |
| Deductions | Standard ($16,100) |
| Income from Job | $70,000 |
| Forgiven Debt | $5,000 |
| Total Income | $75,000 |
| Income Tax Rate | 22% |
| Total Owed to IRS | $7,669.88 |
This chart shows only an individual filing without tax credits except for a standard deduction. Families filing jointly with children under the age of 18 may receive additional tax credits and lower their tax burden. Itemized deductions could also change the tax impact of settlement. Consulting with a tax professional can make the process easier, ensuring you pay only what's necessary and avoid any errors when filing.
Exceptions for Taxes on Cancelled Debt
Some exceptions and exclusions may impact whether cancelled debt is taxed. Here are the most relevant examples:
- Debt cancelled to the extent that you're insolvent
- Debt cancelled in the case of Chapter 11 bankruptcy
- Debt amounts cancelled as gifts, inheritances, devises, or bequests
- Amounts on student loans forgiven under student loan repayment assistance
- Amounts on certain student loans based on employment, student status, and specific discharges between December 31, 2020, and January 1, 2026
How Does Insolvency Impact Cancelled Debt?
Insolvency is the outcome when businesses or individuals can't repay their debts because they have no financial means to do it. This situation is more commonly applied to businesses who face disruptions like the inability to ship or produce goods. However, it can also be used to describe individuals who can't pay back what they owe on credit cards, mortgages, or personal loans.
The IRS defines a taxpayer as "insolvent" when their total liabilities exceed their total assets. It states that "forgiven debt may be excluded as income under the 'insolvency' exclusion." If you prove insolvency to the IRS, you're not required to include forgiven debt as income based on how much you're insolvent. (This means that if you are insolvent by $10,000 but were forgiven $15,000, you are still taxed on $5,000.)
Individuals can claim insolvency by submitting Form 982 and may have some or all of their cancelled debt excluded from their taxes. Consider speaking with a tax professional to confirm that you meet all requirements and complete any tax forms correctly if you plan to claim insolvency.
Individuals can claim insolvency by submitting IRS Form 982 and may have some or all of their cancelled debt excluded from their taxes.
Tax Consequences for Other Debt Relief Options
Tax consequences vary based on the type of debt relief you choose. Here's a look at how each top debt relief option impacts your tax obligations:
| Debt Relief Option | Tax Consequences |
|---|---|
| Debt Settlement | Forgiven debt counts as taxable income |
| Bankruptcy | No tax penalties, but must file current and past taxes |
| Debt Management Plan | Not taxed |
| Debt Consolidation Loan | Not taxed |
| Credit Counseling | Not taxed |
Since other debt relief options except bankruptcy still require you to pay back your debt in full, you're not affecting your taxable income. While bankruptcy may result in some cancelled debts, you're not required to count them as income the same way you file forgiven debt with a settlement.
How To Prepare for Taxes After Debt Settlement
Understanding how debt settlement can impact your taxes is one way to prepare for what you may owe to the IRS. Here are some additional ways to be ready when it comes time to file your taxes for the year you completed your debt settlement:
- Calculate what you'll owe ahead of time.
- Save a little each month for your tax payment.
- Keep important documents for tax filing to submit correct amounts and info.
- Work with a financial professional or tax attorney to ensure you report all settlement forms correctly.
Should You Consider Debt Settlement?
Debt settlement is often an effective choice for consumers who've fallen behind on payments and carry an unsecured balance of over $10,000. Even with the tax consequences, having part of your debt forgiven through a lump-sum settlement could help you finally get caught up on bills and start rebuilding your credit score after the program ends.
Understanding the possible tax consequences of settling debt helps you prepare to resolve debts and cover any fees once the program ends. It also gives you the chance to explore possible exemptions and work with a professional to potentially lessen your tax burden. Once you repay debt, you can start a new financial plan for a thriving future.
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