Settling debt for less than the balance you actually owe involves debt forgiveness. Your creditor is forgiving a portion of the debt owed to them because collecting something from you is better than nothing. But there are IRS rules for your creditors to follow if the amount forgiven exceeds $600.00. Your creditor is required to file a 1099-c notifying the IRS that a portion of your debt has been canceled. You can expect to receive a 1099-c from the creditors you settled accounts with starting in January, for the settled credit cards in the prior year.
It is becoming more common to receive a 1099c regarding entire balances being cancelled by creditors (you never negotiated to pay less than the balance owed).
The amount of your debt that is canceled is viewed as income by the IRS. You therefore must include the amount of debt forgiven as part of your income in tax filings for the year in which you settled debt.
Whether or not you will actually owe and pay taxes on forgiven credit card debt will depend on whether or not you qualify for the “insolvency exclusion”. The insolvency exemption is an asset vs. liability exercise. Solvency has nothing to do with your income as derived from wages or a salary such as from your employer. Solvency for the purposes of determining a tax obligation relating to forgiven debt centers on what you owe vs. what you own.
You will certainly want to speak with your accountant or a qualified tax professional to establish whether or not taxes will be an additional concern, but here are some resources to review, as well as some tips to help you stay organized and prepared, for your tax filings when settling credit card debts.
From IRS Publication 908, page 24:
Insolvency exclusion. A debtor is insolvent when, and to the extent, the debtor’s liabilities exceed the FMV of the assets. Determine the debtor’s liabilities and the FMV of the assets immediately before the cancellation of the debtor’s debt to determine whether or not the debtor is insolvent and the amount by which the debtor is insolvent.
Exclude from the debtor’s gross income debt canceled when the debtor is insolvent, but only up to the amount by which the debtor is insolvent. However, you must use the amount excluded to reduce certain tax attributes, as explained later under Reduction of Tax Attributes.
You, or the tax professional you use, will need to file form 982 related to any exclusion claim you may have. The form 982 can be viewed on page 27 at the same IRS Publication 908 link provided above.
Figuring out taxes on canceled and forgiven debt.
The IRS insolvency quote above uses the abbreviation “FMV”, which stands for Fair Market Value. In other words, what is your stuff worth? You will need to establish the value of the things you own just prior to a credit card debt being settled.
- The value of a car you own outright can be established through the Kelly Blue Book guide.
- Your home’s value can be ascertained by an appraiser or a broker’s price opinion (BPO) where the selling price of comparable homes in your area will be used in establishing the current value of your home.
- If you are underwater in your home’s value (you owe more on your mortgage than the home could be sold for), like many Americans today, the amount you are underwater is a liability, not an asset.
If your home has equity at the time of your settlements, the amount of that equity would be considered an asset.
Simple exercise to test your solvency after settling for less.
Take a blank page and on the left side list all debts you have. Include mortgage debt, amounts you still owe on a vehicle, your credit card debts, any and all debt obligations that were extended to you via credit and loans. On the right side list all of the assets you have, including the fair market value of your home and car, the balance in your checking and savings accounts, your retirement accounts etc. Now add up each column. If the total of your debts on the left side add up to more than the total of your assets on the right, you are what is sometimes referred to as “technically insolvent”. By what amount you are insolvent each time an account is settled for less than the balance owed is what will determine whether you meet the insolvency exclusion and thereby whether you will owe tax on forgiven debt.
Many will owe no tax on canceled debt when applying the insolvency exclusion. Others will not be taxed on the canceled debt of the first several accounts they may negotiate lower pay offs for, but as their unsecured credit card liabilities are decreased one by one through settlement, may find the scales tipped to solvency once settlements are reached on the remaining accounts. Some people will not qualify for the insolvency exclusion.
Should you be concerned about debt forgiveness and taxes from settling credit cards?
Yes, and you should plan and budget accordingly. But should your concern reach to the level of not pursuing debt relief through negotiating the balances down which creates the canceled and forgiven debt and the tax? That will depend. You are reading the debt relief program because you are unable to continue timely payments to your creditors. Did that fact change because you read this report? Not likely. Settling credit card debt is still a legitimate option to avoid filing for bankruptcy. Owing taxes on forgiven debt, if there are any that apply to your specific situation, will simply factor into your overall program design.
What you may now better appreciate is that debts discharged in bankruptcy are not taxed. Bankruptcy is the only legitimate way to eliminated the tax concerns related to debt forgiveness. If you can qualify for discharge of your debts in a chapter 7, and the filing of a chapter 7 does not force the sale of assets, some of which could have been sold to fund settlements and pay taxes (if owed), then chapter 7 is something that you should become more informed about.
What is certain is that you cannot afford your debt. Struggling to pay minimums for however long you have been stuck in a debt trap must end. Keeping this in perspective; owing any amount of taxes on forgiven debt is the result of you saving money and getting out of debt faster than could have been accomplished otherwise.
Update 12/2013: A friend and industry colleague, Charles Phelan, has developed a great tool to help you, or your tax preparer, get through the IRS insolvency form 982. Checkout the insolvency calculator available on his site: http://www.zipdebt.com/1099-C-insolvency-calculator.php
If you have questions about debt forgiveness and taxes related to settling unsecured debts like credit cards, post them in the comments below for feedback.
If you are new to the CRN site and would like to get comprehensive information about settling debt, you will want to read through the debt settlement section of our free online debt relief program. Get started with: An introduction to debt settlement.