Anyone who has had experience with debt relief, especially the process of debt settlement, is aware of how psychologically exhausting the process can be in the beginning. Hopefully you have hired professionals to do this for you to ease the burden and time commitment of doing it yourself. The constant back and forth between debtors and creditors (or debt collectors) can take a few months. The only good thing is the relief you feel when the process is successful and all behind you. Not only were you able to finally settle the issue of your debts, but you were able to do it for a smaller sum of money. You might feel like it is time to pick up the pieces, start improving your credit, and move on with the rest of your life. However, the problem is that there is still something you have to address after having a portion of your debt forgiven – taxes.
The Tax Implications of Settling Your Debt
One of the biggest surprises to debtors is the fact that they end up owing tax on settlements. The reason why they are so surprised by these tax consequences is that they don’t actually receive any cash from debt settlements. This makes it difficult for most people to associate their settled amounts with income. Debtors need to understand the tax implications of settling and that the IRS views write-offs or settled debt as income. They treat this forgiven debt just as they would any other form of income, which means that debtors who were able to settle for less owe federal income taxes. There are legal means to avoid these taxes however, typically involving IRS form 982.
Why the Internal Revenue Service Looks at Forgiven Debt as Income
You might consider it unfair that the debt you worked hard on negotiating away can now cost you more money in the form of income tax. In order to understand why the IRS assesses tax on forgiven debt, it is important to know what happens when a debt is settled. The way it works is that creditors, whether they are banks or credit card companies, report the amount of money a debtor didn’t pay as lost income to the Internal Revenue Service to reduce their own tax burden. The same happens when creditors write off a debt. As soon as collection efforts are stopped and they declare a debt uncollectible, the amount is reported, and the IRS will then view the debt as income.
The IRS will still want to collect tax on the reported sum of money and will turn to debtors for payment. This is because the IRS looks at canceled debt as an income. When a debtor first borrows money, they do not owe taxes on it. They are under an agreement to pay that money back. However, once that agreement no longer exists, any saved money following a settlement is considered the property of the debtor. This is because the debtors are able to utilize the capital to buy products or services for their needs. Once the expectation to pay the money back is no longer there, the money is seen as a benefit gained and requires the debtor to count it as taxable income.
Reporting to the IRS
From a legal standpoint, everyone is required to report all taxable income they receive. This includes debt settlement. Debtors that do not list their settlements as income on a tax return can end up getting a tax bill. Financial institutions that forgive or write off $600 or more of debt are required to send the debtor and the IRS a 1099-C, “Cancelation of Debt” form at the end of the tax year. An IRS form 1099-C is used for any debt that is canceled, discharged, or forgiven. These forms are used for reporting income, which essentially means that the IRS will make sure that the forgiven amount in Form 1099-C is reported as income and subject to federal taxes. Make sure you file your tax return correctly for the tax year in which you have settled debt if you want to avoid additional fees and hassle. If you do not file your taxes yourself, be sure to provide all the necessary documentation to your tax preparer.
Many times, these forms go overlooked. The problem is that many debtors are unaware that a 1099-C form even exists. Other times, the bank decides not to send one out, which negates your liability for the taxes. Many people consider their debts over and done with as soon as the debt settlement is complete. However, people will often end up unknowingly throwing away the 1099-C form just because they come from debt collectors they have settled their debts with. Remember that not receiving a 1099-C form from a creditor is no reason to think you are in the clear. The chances are pretty high that creditors have submitted a copy to the IRS, and you will owe taxes on that forgiven amount. Again, on the other hand, some creditors really do not send them out.
Not All Forgiven Debt is Taxable
Before you start to panic, you should know that there are certain situations under which forgiven debt is not taxable, and in these situations, you may be able to avoid paying taxes. Exceptions to the taxable income rule include:
When an entity is considered insolvent, it means that they are in a state of financial distress and are unable to cover their financial obligations. If a settlement was made during a time period in which a debtor was considered legally insolvent, then the forgiven amount will be excluded from income tax. It is important to note that they will only be forgiven for the amount they were insolvent for.
If a debt was discharged when a person files for bankruptcy of any type, then that forgiven debt is not taxable. There is no limit on forgiven debt when it comes to bankruptcy and taxable income. The only thing that you need to keep in mind is that bankruptcy only cancels debts that existed at the time of filing. A person who files for bankruptcy is not required to pay income tax on canceled debt.
- Certain Student Loan Situations
Student loans can be complicated to understand. This is because they follow a separate set of taxation rules. Student loans are not considered taxable when they are forgiven under specific loan provisions. This applies to loans that the government, a public company, or schools (which has programs that benefit underserved areas) give out. Private education loans do not fall under these nontaxable rules, and debtors will have to pay taxes on the amount that is forgiven. Student loan debt is also not looked at as a taxable income if a person works them off with certain employers. However, a student loan that is forgiven under other circumstances, such as a debtor not being able to pay, is considered taxable income.
Form 982 to Waive Tax Liabilities
As you can see from the situations above, there are certain situations where an individual is not expected to pay income tax on settled debts. While they are not required to pay, it is their responsibility to inform the IRS of those exceptions by filling out the proper forms and attaching them to their tax return. In order to do this, you need to fill out Form 982. This form determines the forgiven amount of debt that can be excluded from your overall income.
As stated above, there are exceptions to the laws governing tax liability for debts canceled or forgiven, but taxpayers must inform the IRS of those exceptions by filling out Form 982. If a debtor was insolvent or had debts discharged through bankruptcy, they must account for that on the form.
As you can see, there are still a couple of things you need to do once you complete your debt settlement. The good news is that the tax debt you pay is less than the amount of money you would have paid to cover the entire debt owed. Taking care of your tax obligation after settling your debt will be the final step of starting over, living debt-free, and being rid of calls from debt collectors. If you need help with handling your debt or need legal advice associated with debt settlement, contact Churchill Credit Solutions.