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 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 each year through debt settlement. 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. A lot of people assume that debt settlement is non-taxable and end up not paying any kind of taxes related to them. This invites trouble with the IRS, and you may face legal and financial issues down the road.
Understanding the Concept of Debt Settlement
Before we discuss what happens with the money you save, it is important that you 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. For example, if you owe $15,000 to a creditor and they choose to waive off $5000 after you’ve paid back $10,000, the amount of $5000 is your debt settlement.
In effect, the creditor will accept your debt as back paid in full even though you paid only a part of it. 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 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 for them. 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. 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 kind of tax on your settlement.
Strategies to Avoid Paying Taxes On Settled Debt
Keep in mind, 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. In addition to what’s listed below there are also numerous tax strategies you can look into that 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 important 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 smaller 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 important 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. Debt settlements are taxable income and taxed according to the same criteria. However, there are exceptions where a debt settlement may not be taxed.
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 blog 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!