When hard economic times happen, debt settlement can seem like a very appealing option. Maybe you lost your job, your income was reduced or you had your income affected by a large medical expense.
For these reasons, you may have fallen behind on your bills and the creditors are now on your back!
You failed to pay your debts and now one of your creditors has lost hope getting you to pay up. For reasons known to them, they’ve decided to stop trying to collect their debt and may have decided to write off your debt.
While you may be feeling relieved, what seems to be a good fortune to you may turn out to be a tax nightmare!
Below, are some things you need to be aware of regarding settling or having large amounts of debt forgiven. If you’re not 100% sure on how this affects your financial situation you to need to seek out a finance professional for help!
Believe it or not, I was in a similar situation during the last great recession of 2008. If it was not for my CPA, I would have had some big tax problems and possibly owed over 100,000 dollars to the IRS. Yeah, No Joke!. Here’s what I learned. (btw… This is not financial advice, just some ideas to get you in the right direction.)
A Creditor will File for Form 1099-C
As a debtor, your creditor’s decision to cancel your debt obligation may sound like good news to you. However, the bad news is; a creditor will file for a Form 1099-C with the IRS.
Here is a practical example; if you have a 100k debt on student loans, a mortgage or credit cards and paid down 50k off the principal. Then after some time, say two or three years, you default on the remaining debt and the creditor has decided to write it off.
The creditor will report the remaining 50k that you owe them as an uncollectible debt. If they don’t end up filing a lawsuit to get this money it’s a pretty good chance it will be forgiven instead.
They’ll report it the revenue authority as lost income so as to reduce their tax burden. Generally, the IRS will not forfeit the debt. Instead, they’ll consider it as a forgiven debt and will still want to collect tax on it and will turn to you with Form 1099-C for payment.
The reasoning here is that IRS treats the written off amount or forgiven debt as gained income and requires you to pay income taxes on it!
As you probably already know, owing money to IRS, especially in the form of unpaid taxes is the worst type of debt you could ever wish for. It becomes stressful and borderline nightmarish particularly when you don’t have funds to pay.
In terms of debt settlement and the written off debt, you’re likely to forget that you’re on the IRS’ hook for debt settlement tax when you do not receive any cash. In fact, you may not know that settled debt, which was basically written off by the creditor, is considered income for which you must pay income tax!
So before you run mad and think that the IRS is stealing from you, just know that it is part of the federal law for forgiven debt to be taxed.
The IRS is under obligation to collect that debt settlement tax. There are however exceptions and many ways to go about such situations. To better understand how this works, let’s use the 100k debt example and see how debt settlement tax would apply in different situations.
Credit Cards and Personal Loans
Assume that you’ve taken 100k credit cards or personal loans. After paying 50k, you’ve been unable to pay the remaining 50K and have chosen to look it debt settlement options. The creditor, through the debt collecting company will give you an option of paying 30k of the remaining 50k so that they can forgive you the last 20k. You jump on it thinking that it’s a good idea but before you know it, the IRS is on your neck for income tax on the 20k!
The idea here is that the debt collecting company or the creditors has sent Form 1099-C (as required by law) and reported the 20k as your income. This is so that they do not get taxed on the money they didn’t receive in the first place because you defaulted on your payment. In short, this 20k becomes an income and you must pay an income tax on it. Keep in mind that some debt settlement companies may not have the courtesy of informing you that you owe taxes on the forgiven debt.
There are a number of exceptions to taxable income on forgiven debts. This is where mortgage debts and student loans come in.
Although it’s currently not an effective federal law, Congress passed the Mortgage Forgiveness and Debt Relief Act of 2007. This act generally stated that if you had your home loan forgiven for loan modifications, foreclosures and short sales between 2007 and 2017, you couldn’t be liable for taxable income. For instance, if a creditor wrote off 50k of your mortgage, it couldn’t be counted as an income as was the case prior to 2007.
It’s important to note that the exception applied to the first $2 million of the qualifying debt. Anything above that would be subjected to regular taxable income. While the initial act was expected to last until 2012, it has been renewed each year through 2017 but is yet to be renewed.
BTW… I had a similar issue with some forgiven mortgage debt in 2009, my CPA was a lifesaver in getting it resolved for me. I was using Turbo Tax that year and it did not know about the laws that had passed, it was convinced I owed over 50k in income taxes. With professional help, I got a big fat income tax return instead.
A forgiven student loan cannot be considered a taxable income if it’s wavered under certain terms. For instance, it might not be taxable if it’s forgiven because you moved to a different profession.
You should, however, keep in mind that this is only applicable to loans offered by through government programs, schools that have programs for underserved areas or a public company that’s exempted from tax.
However, the IRS will expect you to still pay taxes on the loan. Especially, if it was forgiven because you’re unable to pay due to your financial situation!
Insolvency is the most common debt settlement tax exception that you can pursue. Generally, you’ll be considered insolvent if your total assets are exceeded by your total debts. When you’re insolvent, the forgiven debt is removed from taxable income but to a specific amount.
Let’s go back to our 100k example. Suppose all your assets including car, home, investments and retirement savings are worth 100k. Unfortunately, you have a 120k debt on your mortgage, student loans, and credit card debts. You’ll be considered insolvent since your total debts surpass your assets by 20k. Now suppose that your debt was 140k, only the first 20k will be exempt from tax and so you’ll have to pay tax on the other 20k.
Forgiven debt cannot be taxed if you file for bankruptcy. Unlike insolvency and mortgage loans, there are no limits or specific amounts on forgiven debt when it comes to bankruptcy. All you have to do is ensure that the debt was in existence by the time you filed for bankruptcy.
To this end, there’s no doubt that debt settlement can turn into a stressful tax nightmare. Generally, the IRS will require you to pay taxes on forgiven debts unless there are exceptions.
It’s up to you to notify the IRS any existing exception through Form 982, whereby you should clearly state the forgiven debt that should not be included or perceived as your gross income and the reasons why they should be exempted.
Before agreeing to be part of any debt settlement program, it’s advisable to seek the services of a tax professional first. He should review the program and advise you accordingly as to which exceptions would be a better fit for your situation.