How a Debt Settlement Can Effect Your Taxes

Often people facing a financial set back will approach their creditor either directly or through an intermediary such a credit counseling or debt management company to seek debt relief. While this is relatively easy to do and many creditors are open to negotiation these days, be advised that such a debt settlement could have negative tax ramifications. If you settle a debt with a creditor or the creditor writes it off as a tax loss (essentially declaring it uncollectable), you could owe money to the IRS. Debts subject to this rule include credit card defaults, property repossession, or money you owe after a foreclosure.

A credit card company, government agency, bank, credit union, savings and loan, or finance company that forgives or writes off $600. or more of debt principal (not including interest and fees) must submit a Form 1099-C both to you and the IRS. You are then obligated to report this amount as income on your federal income tax return with the following exceptions:

* A student loan canceled because you worked as promised when you took out the loan in a profession and for a specified employer.
* A mortgage on your principal home of less than $2M if you file single or jointly with your spouse ($1M if you file individually with your spouse) that was wholly or partially forgiven between 2007 and 2012.
* A non-business debt canceled before 2007 as a result of Hurricane Katrina.
* A canceled debt that would have been deductible if you had paid it.
* A debt discharged in Chapter 11 bankruptcy.
* Cancellation or write-off of a debt intended as a gift (highly unlikely).
* You were insolvent (your debts exceed the value of your assets) before the creditor agreed to waive or write off the debt. You can avoid reporting the debt as income only to the extent that you were insolvent.

If you receive a Form 1099-C and you want to claim an exception, you need to file an IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness form. This form can be complicated, especially if you are claiming the insolvency exception, so you might want to consult an accountant to ensure it is properly completed. They can also assist you making the necessary changes on your tax return.

A debt settlement in which your creditor agrees to settle for less than the original amount can affect your tax liabilities. While this may appear to eliminate all your problems in the short term, it can complicate your tax situation. Hiring a competent accountant to review your circumstances can guarantee that you stay on the right side of the IRS.

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