It’s already challenging to file taxes, but what happens if you recently settled your debt? Are you supposed to pay taxes on the money you saved? Or are these savings considered income that the IRS won’t tax because you technically didn’t earn it? Not surprisingly, many people in the US who recently completed a debt settlement program are left scratching their heads when it’s time to file their tax returns for the year. The whole situation is even more confusing when you don’t know how much money you saved or what percentage of the savings went to fees or other administrative costs.
Hundreds of thousands of Americans settle their debt yearly through debt settlement programs. Many settle their credit card debts independently, but some enroll in certified debt settlement programs where they often see a 40 to 60% reduction of their principal amount owed. The amount of money they save can be life-changing, and most importantly, they no longer have to deal with aggressive debt collection tactics. However, they often don’t know whether or not they should declare these settlements to the IRS and pay tax on them. In other cases, people get letters from their creditors informing them that their settled debt is taxable, creating additional confusion. Many people assume that debt settlement is non-taxable and end up not paying any related taxes. This invites trouble with the IRS, and you may face legal and financial issues.
Understanding the Concept of Debt Settlement
Before we discuss what happens with the money you save, you must understand how debt settlement works. Debt settlement, in the simplest words, is any amount of debt that the creditor (an individual, a bank, or any financial services organization) decides to waive off for any reason whatsoever. Unsecured debt is typically reduced and settled by creditors because of specific financial hardships. Most credit card companies have processes where you can settle your debt on your own with an established debt settlement company. For example, if you owe $15,000 to a creditor and they choose to write off $5,000 after you’ve paid back $10,000, the amount of $5,000 is what you save through debt settlement. You’ll pay the creditor $5,000; both parties will consider this debt settled and paid off.
In effect, the creditor will accept your debt as paid in full, even though you paid only a part. There can be many reasons why a creditor might decide to reach a debt settlement with a debtor. These reasons include the debt amount being canceled as a gift, inheritance, filing for bankruptcy, insolvency, etc.
Is The Money You Saved Through Debt Settlement Taxable?
Yes, according to United States tax laws, debt settlements are taxable. The laws recognize debt settlements as taxable income, meaning they must be mentioned in the tax returns and appropriate taxes paid. Furthermore, settlements are taxed just as ordinary income. This means that you can expect to pay a tax ranging from 10% to 37% of the total amount of your debt settlement.
Creditors must also report debt settlements of over $600 to the IRS, often done with a Form 1099 Form 1099-C, Cancellation of Debt. This form shows the amount of debt cancelled and the date when the debt was forgivent You may get in trouble if you fail to declare and pay tax on your debt settlement. However, there are a few exceptional situations where it may be acceptable for you not to pay any tax on your settled debt.
Strategies to Avoid Paying Taxes On Settled Debt
Remember, these strategies to reduce your tax liability with debt settlement aren’t for everyone, and some methods won’t work for certain types of debt. For example, you can’t settle secured debt as there’s some collateral backing up the loan. The same applies to student loans and other government loans, where you agreed to repay the entire balance. In addition to what’s listed below, numerous tax strategies you can look into may postpone or limit the amount of money you’ll pay when debt is forgiven.
Filing For Bankruptcy
Bankruptcy is a special legal status in which the court declares an individual or a company unable to pay back their debt. Specific debt settlements resulting from Title 11 bankruptcy are not taxable. It is essential to understand that this includes Chapter 11, Chapter 13, and Chapter 7 bankruptcy. Chapters 7 and 13 are for individuals, and Chapter 11 is for companies.
Insolvency
Insolvency is when an individual’s or a company’s assets are less than their total debt. This automatically puts them in a situation where they cannot repay their debt in full.
The creditor can decide to waive off an individual’s debt in case of insolvency, and this often occurs when it’s not worth the hassle for a lender to collect on a debt. Debt settlements reached in such cases are non-taxable. However, it is essential to note that only the amount by which you are insolvent is not taxed. For example, if you owe a creditor $70,000 and your total assets are $50,000, you’re insolvent by $20,000, which will not be taxed.
Avoid Paying Taxes on Debt Settlement
Any loan forgiveness by a creditor is termed a debt settlement, and with that amount you save, there’s a good chance the Government will come after you for their piece of the savings! Debt settlements are taxable income and taxed according to the same criteria. However, there are exceptions where a debt settlement may not be taxed. These include situations where the settled amount was less than $500 or if a financial expert or CPA feels you don’t need to pay taxes on the settled debt for whatever reason.
At Gateway Debt Relief, we’ll work to get you the best settlement amount for your unsecured debt. After you’ve paid off your creditors, it’s up to you to determine if you need to pay taxes on the settled debt. When paying taxes on debt settlement or any other “earned income,” it’s best to consult a licensed financial expert, as the laws regarding IRS regulations are constantly changing.
This article post has listed a few legal strategies that may help you minimize taxation on your debt settlement. However, given that taxation is a very delicate matter with various complicated legalities and loopholes, it is recommended that you consult a professional tax consultant or debt settlement company if you’re looking for more information on taxes and debt settlement. Call Gateway Debt Relief at 888-560-0132 to learn more about debt settlement options.