Whenever you borrow money, you have a legal obligation to repay it in full. Settling debt for less than you owe is a possibility. But because it means you’re not completely fulfilling your obligation, there may be tax consequences.
When settling credit card debt, tax implications may include treating the settled debt as taxable income. However, understanding the implications of paying taxes on a debt settlement, as well as understanding your own financial situation, can help you know what to expect, and in some cases, minimize what you owe when you settle your debt for less than you owe.
What happens when you settle credit card debt?
Debt settlement is a common form of debt relief. It typically occurs when a borrower is delinquent or in default on their debt. The borrower or a debt settlement professional negotiates with the creditor for an amount less than what is owed. Often, the settlement is fulfilled with a lump-sum payment or a payment plan. The creditor is more likely to negotiate a settlement if they feel as though it is the only way they will recoup any of the debt because you are delinquent. However, when you settle your credit card debt, you are completing your responsibility to the creditor, but the creditor is required to report your savings to the IRS.
What are the tax implications of settling credit card debt?
Because the creditor essentially forgives a portion of your credit card debt, the forgiven amount may be considered taxable income. The creditor will report the forgiven debt to the IRS. This may affect both your federal and state income taxes.
The 1099-C Form
If you settle credit card debt for more than $600 less than what you owe, the creditor is required to send you a 1099-C form at the end of the tax year. When you file your tax return, you will need to report the amount of the forgiven debt on this form. If you don’t receive this form from the creditor, they may have still reported the income to the IRS. But if you don’t report the income and the creditor has, you may receive a tax bill or be audited. Therefore, it’s important to know if you must report this income to avoid paying more in tax penalties.
Are there exceptions to these tax implications?
However, even though you are not repaying your debt in full, there are instances in which you may not face tax implications.
- Insolvency: Insolvency is one of the most common exceptions to the tax implications of settling credit card debt. Insolvency means your total debts exceed your total assets. If you are deemed legally insolvent, you are excluded from being taxed on your forgiven debt, but only up to the amount you are insolvent. For example, say you have $100,000 in assets but $120,000 in debts. This means you are $20,000 insolvent. If your creditor has settled your credit card debt for $30,000 less than what you owed, you are excluded from being taxed on the $20,000, since you’re insolvent. However, you must pay taxes on the remaining $10,000 that was forgiven.
- Bankruptcy: If your credit card debt is forgiven in bankruptcy, it cannot be taxed. This is true for any type of bankruptcy. And with bankruptcy, there is no limit on forgiven debt that will be excluded from being taxed.
How does the IRS know you’re exempt?
If either of these exemptions applies to you, you have to notify the IRS.
You will fill out Form 982 to inform the IRS of your exemption. This form determines how much of the settled credit card debt is excluded from the tax implications. You will need to include the amount of the forgiven debt provided on the 1099-C form. The lender is required to send you a 1099-C form regardless of any possible exemptions you may have. If you neglect to fill out Form 982, it could raise suspicion from the IRS.
Is it worth it to settle credit card debt?
The idea of settling credit card debt for less than you owe may seem too good to be true. But paying taxes on the debt settlement may be the catch. However, understanding the exemptions can also help you determine whether it’s worth it for you. Many individuals who are in debt trouble are insolvent. Knowing the value of your debts compared to your assets can give you a clearer picture of whether you would owe taxes and how much you may be taxed on.
However, even if you are not exempt through insolvency or bankruptcy, settling credit card debt may be worth it for you, even with the tax implications. Most often, what you’ll pay in taxes on debt settlement will still save you money.
And settling credit card debt can have longer-term positive implications on your financial situation:
- Lower debt-to-income ratio: Settling credit card debt lowers your total debt, which in turn helps your debt-to-income ratio. This can help you be more attractive to lenders and be more financially stable overall.
- Cleaner credit report: While settled debt will be reported as “settled” rather than “paid in full,” this is still preferable to a delinquency or a default on your credit report. This is particularly important because payment history is the most significant factor in determining credit scores. This can actually boost your score.
- Lower credit utilization: Settling your credit card debt will also lower your credit utilization. Your credit utilization is the amount you’ve borrowed versus the amount of credit you have available to you. Your credit utilization should ideally be below 30 percent. This is another significant contributing factor to your credit score.
Where can you turn for help?
Talking to a financial professional, such as a debt attorney, can help you understand the tax implications of settling credit card debt. A debt attorney can assist in navigating the complicated processes and criteria involved when settling debt and dealing with creditors. A debt help attorney can also guide you through the credit and debt management process, focusing on strategizing the best ways to resolve the debt, saving you money and time, and helping relieve the stress and fears from having credit card debt.
The team at Tayne Law Group, P.C., is here for you on this journey. If you’re having debt trouble or have questions about paying taxes on a debt settlement, our team of experienced professionals can help. Call us for a free consultation at 866-890-7337 or fill out our short contact form and we’ll get in touch!