Tax Implications of Debt Settlement
Tax Implications of Debt Settlement
What is debt settlement?
Debt settlement is also referred to as debt arbitration or negotiation and is an approach to the reducing of personal debt. It is a method in which the creditor and the debtor agree to reduce the balance of a financial obligation so that when that reduced amount is paid off it is regarded as being paid in full. Additionally, creditors will not negotiate a reduced balance if you have been maintaining your regular payment schedule. If the payments are curtailed or stopped, that balance will increase based on interest and late fees.
The consumer has some options for arranging their own debt settlements including:
- hiring an attorney to assist them
- hiring a debt settlement company
- using the advice that they find on an online debt settlement website
Since there is the distinct possibility that the debt settlement company may charge an individual a large up-front fee for their services, or take the monthly fees from the person’s bank account, many consumers may be reluctant to pursue debt settlement. We suggest that you search for a debt settlement company that only charge you the fees for their service once the debt has been settled. It is not uncommon for these fees to equal up to 20% of that amount that the outstanding account balance has been reduced by.
The most common objections to debt settlement
There are 5 primary objections to pursuing debt settlement. These are:
- damaging one’s credit history and score
- an increase in the number of collection calls
- needing to settle with every creditor, not just one
- the possibility of numerous lawsuits
- the tax consequences
The bottom line is that you can still be sued by your creditor(s) as well as it damaging your credit history and score.
What are the tax consequences or implications of debt settlement?
Most importantly there are tax consequences that you should be aware of. When a debtor’s obligations are canceled (in part or wholly) and this has not resulted from filing bankruptcy, the canceled portion of the debt is viewed as taxable income by the IRS. This is actually the biggest objection that most consumers have to debt settlement.
According to Form 982 (IRS publication), anything over $600 in discharged or forgiven debt is considered taxable income. However, the IRS does not require this income to be reported should you be deemed insolvent. Insolvency is defined as when your debts exceed your assets. Additionally, and we are quoting the IRS ruling “you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent” (IRS Publication 525).
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