- 6 min read
- You may be able to avoid paying taxes on debt forgiven through debt settlement
- Understand the steps to take if you receive a 1099-C
- Cancellation of debt income is the legal, IRS-approved way to avoid debt settlement taxes
Did you settle a debt for less than the full amount due?
If you did, you may have to pay federal income taxes on the amount forgiven. But there are little-known and completely legal steps you can that may allow you to avoid this tax. If you received an IRS form 1099-C from a creditor or lender, it's important to understand how best to handle taxes resulting from debt settlement.
You may wonder why you have to pay tax on a debt settlement, of all things. Federal tax rules focus on your income, and in the eyes of the IRS cancelled debt might be considered in some circumstances.
Forgiven debt taxes can best be explained with an example. Let's say you rack-up $10,000 in credit card debt, which you cannot pay. In our example, the credit card company agrees to settle the debt for $4,000, forgiving the remaining $6,000. The creditor notifies you and the IRS of the forgiveness using a form 1099-C.
Congress directed the IRS to treat forgiven debt as income because Congress took the position that people with forgiven debt are enriched -- they receive income equaling the amount forgiven. In our example, the amount forgiven is $6,000. Therefore, you need to tack $6,000 on to your income for the tax year the debt is forgiven.
Handling a 1099-C
The 1099-C is the tax document that a creditor or lender is required by law to issue if a debt of more than $600 is forgiven. The creditor/lender sends a copy of the 1099-C to you and to the IRS.
Never ignore a 1099-C. If you do, the IRS gets a copy anyway. If you don't account for it in your tax return, the IRS will catch your ommission and not only hit you with a tax debt, but add on penalties and interest, too. Sometimes, it takes a couple of years for the IRS to make an adjustment, which means a couple of years of taxes and penalties!
You may not need to pay any taxes as a result of receiving a 1099-C.
You do not need to pay any taxes if you meet the IRS' standards for hardship, which is based on how the IRS views your assets and liabilities.
If the IRS views you as insolvent, you don't need to declare the forgiven debt as income.
Depending on the size of the debt, a 1099-C can result in a large tax debt. If you had a very large debt forgiven, the taxes you owe could be significant.
There are people who've had large mortgage or credit card balances forgiven that the forgiven debt not only resulted in a big tax bill, but the income they had to declare from the forgiven debt pushed them into a higher tax bracket.
Becuase the IRS Form 982, described below, can be confusing, seek advice from a tax professional if you receive a 1099-C.
Do It Yourself
Some people prefer to handle their taxes on their own, even when a normal person would seek professional assistance.
Take these three steps if you receive a 1099-C and feel up to handling the matter on your own:
1. Download An IRS Form 982 (PDF)
The amount of debt forgiven must be reported on an IRS Form 982, which must be attached to your tax return. The Form 982 will guide you through the insolvency test.
2. Tally Your Assets At The Time The 1099-C Was Issued
Add up the fair market value of assets you owned immediately before the 1099-C was issued. What does fair market value mean? For things you own, the fair market value is what you would reasonably be able to sell the items for at a garage sale or through Craigslist. For retirement accounts, use the present balance of your accounts if you were able to retire today.
2. Tally Your Debts and Liabilities
Your liabilities include the entire amount of each debt you owe, including loans you co-signed. You debts will include:
- The debt mentioned in the 1099-C
- Credit card debts
- Student loans
- Vehicle loans
- Unpaid tax liability
- Other debts, such as judgments
3. Subtract the Amount of Your Debt From Your Assets
If your debts are more than your assets, then you owe no additional taxes. Complete Form 982 with your numbers, and include it with your next tax return.
If your assets are larger than your debts, then you may have to pay some additional taxes. How much you need to pay on this cancelled debt depends on your amount of assets and liabilities. See IRS Publication 4681 for specific instructions on how to complete Form 982.
Two IRS Examples On Debt Settlement Taxes
IRS Form 982 and Publication 4681 contain several examples to explain how to calculate how much tax you may owe. The table below illustrates two simple examples:
|Cancellation of Debt Income Worksheet|
|Total Liabilities||Asset Fair Market Value||Insolvency Amount How Much Can Be Excluded From Income|
|Greg Example No. 1||$15,000||-||$7,000||=||$8,000 Because this exceeds the amount of cancelled debt, Greg can exclude the entire $5,000 shown on his 1099-C.|
|Greg Example No. 2||$10,000||-||$7,000||=||$3,000 Because this is less than the amount of cancelled debt, Greg can exclude only $3,000 of the $5,000 shown on his 1099-C.|
|Note||See IRS Publication 4681 for more information and instructions on how to complete a Form 982|
How the IRS calculates your insolvency. Source: IRS & Bills.com
1099-C and Debt Settlement
If yoU are thinking of hiring a debt settlement firm or doing a settlement on your own, weigh the tax consequneces. No matter your tax bracket, you will save money by doing a settlement. For instance, if you had a $10,000 debt that was forgiven for $4,000, you would get a 1099-C for $6,000.
If you did not meet the IRS' insolvency test and had to declare the $6,000 as income, you would need to pay taxes on that amount. However, you are still saving a lot of money.
Think of it this way: Would you rather pay taxes on $6,000 or pay $6,000? No matter what tax bracket you are in, your taxes owing from a settlemetn are going to be far less than if you paid back the entire debt. When you factor in the interest your creditor was charging you, your savings are even greater from settling the debt.
Bills Action Plan
If you receive a 1099-C, take the folowing steps:
- Never ignore a 1099-C.
- Speak with an experienced tax preparer. It's wise to make sure the Form 982 is filled out properly and that the calculations of your are assets and liabilites are done correctly.
Also, if you have a debt forgiven but don't receive a 1099-C, be sure to raise that with a tax professional. If the IRS got a copy and you did not, you could still be responsible for taxes, interest, and penalties when they revise your return.