Tax Consequences of the Debt Settlement

Being a popular alternative to filing for bankruptcy, debt settlement also brings a number of significant disadvantages to the person resorting to the help of a debt settlement agency. One of these disadvantages are its tax consequences.

Every time a debt settlement is reached, a creditor will report the amount of canceled debt (in case it is equal to $600 or greater) to the IRS through the Form 1099 (this is obligatory and there is no legal way to escape it). The canceled part of the debt is considered to be taxable income of the debtor, therefore, you might owe taxes on this amount. This fact triggers a lot of criticism aimed against debt settlement – basically due to the fact that a debtor in financial hardship may end up owing taxes to the government, which only adds to the existing problems. However, in most cases the tax consequences triggered by the process of debt settlement are not as bad as people usually think and say them to be.

First thing that you should remember when weighing the “dangers” of tax consequences is that the sum of the money that you pay to the creditor plus the taxes that you might have to pay in the future will still be much lower than the sum of your outstanding debt. Therefore, it’s pretty hard to consider such tax consequences to be a major disadvantage able to stop a debtor from resorting to the help of a debt settlement agency.

In addition to that, one should be aware of the fact that the majority of debtors reaching a debt settlement with their creditors are not obliged to pay taxes on the canceled part of the debt due to the so-called insolvency rule (you can read the full description of this rule in IRS Publication 908, "Bankruptcy Tax Guide"). Most people usually get mislead by the title of this publication assuming that filing for bankruptcy is a necessary condition for taking advantage of the insolvency rule. This is not true.

In reality, “insolvent” status of the debtor only means that the amount of his/her debts exceeds the amount of assets he/she owns. Thus, you can see that most debtors trying to reach a debt settlement with their creditors will be considered insolvent and will not have to pay taxes on the canceled part of the debt. The negative tax consequence is most likely to hit only the debtors with enough equity in property (home, car, etc) to outweigh the net amount of the owed money. In this case (if your net worth is positive) you WILL have to pay taxes on the canceled part of the debt. However, the number of such debtors compared with the number of insolvent ones appears to be truly insignificant.

You are strongly recommended to seek professional tax advice specific to the situation you are currently in long before the tax time comes. You should also make sure to read the part of IRS Publication 908, which concerns the “reduction of tax attributes”. It requires insolvent debtors to reduce their basis in such matters as rental property, loss carryovers, etc. We advise you to consult a tax professional before trying to wing it.

As you might see from the information stated above, the tax consequences are not the thing to be afraid of when resorting to the help of a debt settlement agency (in case you are really living through certain financial hardships).