If you have reached a settlement agreement with a creditor to repay a debt for less than the balance due, the Internal Revenue Service calls this "canceled" debt.
Under federal tax law, forgiven or canceled debt is considered income for tax purposes. Accordingly, a creditor is required to submit a 1099C to the IRS for any debt forgiveness exceeding $600 in value. Therefore, a consumer would be wise to consult with a certified tax preparer, CPA, or tax attorney with respect to the implications of being taxed on the forgiven debt. See the IRS page Cancellation of Debt.
Generally speaking, many creditors do not issue 1099Cs, and as a result consumers do not pay additional taxes on the forgiven debt. Many consumers who do receive 1099Cs do not see a significant tax penalty because their severe financial hardships are usually the result in significant loss of income, or events that allow for tax credits. IRS Form 982 covers certain hardship situations that may exempt or offset the tax liability caused by a large 1099C debt forgiveness.
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