How Debt Settlement Affects your Taxes
Many people see ads for debt settlement and think it is the best way to put debt behind them without having to resort to bankruptcy. However, debt settlement, where creditors forgive some or all of a person's debts, can have profound consequences at tax time. Forgiven debt is considered as income by the IRS unless you have proof that your forgiven debt qualifies for an exception. Any time a creditor forgives more than $600 in debt, the creditor must send you a 1099-C form. Creditors must also send a copy of the form to the IRS, so you can't just ignore these forms. The IRS expects to get 2.8 million of these forms in 2011.There are six exceptions to the requirement that you report forgiven debt as income.
Exception 1: Debt taken out to purchase or improve your primary residence. Legislation from 2007 states that this type of forgiven debt doesn't count as income. However, money borrowed against your home to pay for other debts still counts as income.
Exception 2: Bankruptcy. If you filed Chapter 11 bankruptcy and had debts discharged, these debts generally don't count as income.
Exception 3: Certain debts related to farming or business. If your forgiven debts are related to real estate purchased as part of a business or if they are related to professional farming, they are generally not required to be reported as income.
Exception 4: Cases of insolvency. If you owe more than what your net worth is before debt settlement, forgiven debt up to the amount by which you're insolvent isn't counted as income. For example, if:
- Your net worth before debt settlement = $6,000
- Amount of your debt that is forgiven = $10,000
- You may exclude up to $4,000 of forgiven debt from your income. $6,000 minus $10,000 gives you a "net worth" of negative $4,000, making you officially insolvent.
Exception 6: Debts forgiven due to gifts. For example, if your mother lends you $10,000 to pay off debts, then says, "Don't worry about paying me back," the $10,000 is not taxable. However, you need proof, so you would need your mother to write a promissory note that shows your debt to her as canceled.
If you have a debt of less than $600 forgiven, the creditor does not have to send you or the IRS a 1099 form. However, if the IRS finds out about it, they will want you to count it as income, so be careful about "forgetting" smaller forgiven debts.
For some people, debt settlement is the best way to get rid of debt, but before you pursue debt settlement, consider the tax consequences carefully. If you're in a higher tax bracket, you could end up owing the IRS something like $300 on every $1000 of debt forgiven. In other words, you might not owe MasterCard, but suddenly you owe the IRS. Speaking with an accountant is highly advisable before pursuing debt forgiveness.
Sources:
http://www.taxrelief.net/debt-settlement-taxes.htmlhttp://www.beatingbroke.com/how-debt-settlement-will-affect-your-taxes/
http://askthemoneycoach.com/2011/03/1099-c-forgiven-settled-credit-card-debt/
http://www.creditcards.com/credit-card-news/six-exceptions-paying-tax-forgiven-debt-1282.php
http://www.investopedia.com/articles/tax/09/tax-bill-debt-settlement.asp#axzz1heJuMaBw
