Debt Relief and Taxes: How Your Return May be Impacted
When you borrow money in any form, you are legally responsible for repaying that debt. While debt relief can dramatically help improve your financial situation, circumstances in which you’re getting out of debt without paying off your full balance can have an impact on your taxes.
By understanding how debt relief and taxes are related, you can be prepared for what to expect when filing your return.
Debt Settlement and Taxes
When you go through a debt settlement process, your debt is generally paid off in a lump sum. This sum is generally less than the total balance of what you owe. Creditors may accept this negotiation because they would rather recoup a portion of what you owe than none of it. This is generally only effective if you’re delinquent on your debt. However, because you were legally responsible for paying that full amount, the amount that was forgiven is essentially free money. Therefore, the IRS views this as income, and furthermore taxable income.
If you’ve had more than $600 of debt forgiven, the creditor will issue a 1099-C form in January. This form details the amount of debt you had forgiven. The creditor will also send the form to the IRS, as well as to your state or local tax collection office.
If the creditor neglects to send you a 1099-C form when you’ve had more than $600 of debt forgiven, don’t think you’re off the hook. You should still report the forgiven debt in your taxable income because the creditor may have still reported it to the IRS. A discrepancy could throw up a red flag on your return. While the thought of having to pay taxes on your forgiven debt may burst your celebratory bubble of getting out of debt, don’t panic. Generally, you will pay less in taxes than the amount you originally owed. Therefore, while your taxes will be impacted, you’re still reaping the benefits of debt relief.
Exceptions to Debt Relief Tax Consequences
Additionally, certain circumstances can create exceptions to debt relief leading to taxable income:
- Insolvency: Insolvency is when you have more debt than you have in assets. If you are deemed legally insolvent, your forgiven debt will not be counted as taxable income. However, the amount that you are insolvent will not be taxed. The amount you are insolvent is the difference between your debt and assets. Any remaining forgiven debt will still be taxed.
- Bankruptcy: Any debt discharged through any form of bankruptcy is not subject to be taxed.
- Gift loans: If a friend or family member lends you money with no expectation of you paying the money back, this money is not considered taxable income.
- Student loan cancellation: Student loan cancellation has been a popular topic of late, especially with programs such as Public Student Loan Forgiveness. If a student loan is forgiven through one of these programs that benefit those that work in certain professions, it will not be considered taxable income. These programs are generally only offered for federal student loans. Similarly, if you work off your student loan through your employer, it will not be taxed. However, if your student loan was forgiven under circumstances such as an inability to pay, it will be taxed.
Debt relief can be an incredibly helpful process. But it’s important to remember that you have a financial responsibility that doesn’t just go away. Many borrowers may not know that debt relief and taxes are related. This can cause panic when they discover that they will be taxed on their forgiven debt. Understanding the repercussions of debt relief on your taxes will prevent you from facing that shock.