Debt settlement money as taxable income

You’ve gone through the process of debt settlement and negotiated with the creditors to write off some of your debt. You are breathing a sigh of relief. Unfortunately, it’s not over yet. If you’ve had more than $600 of debt written off, the creditors are obligated to report this to the IRS. The money you saved is considered taxable income.

For example, say you owed $20,000 on your MasterCard. You negotiated with the card company to have that debt reduced to $12,000. Thus, you’ve saved $8,000. That amount is called Discharge of Indebtedness and is taxable income. The lender will send you Form 1099 outlining the exact amount that was written off. It’s as if you earned $8,000 and gave it to the lender. You owe the IRS taxes on that amount. And even if the lender neglects to send you the correct paperwork, you still owe the taxman.

When is it not considered taxable income?

There are three situations in which debt reduction is not considered taxable income. The first is in a battled contest. For example, say you see a charge of $2,000 on your credit card for a laptop. You know that you did not buy a new laptop, so you challenge the charge. The credit card company is reluctant to refund the money. Your case winds up in court. In the end, you agree to pay $200 of the $2,000 charge. The credit card company agrees to erase the remaining $1,800 in debt. That amount is not considered taxable income.

If your debt is reduced because you have filed for personal bankruptcy, you are exempt from the Discharge of Indebtedness income rule. For example, say you’re $50,000 in debt. You file for chapter 13 bankruptcy. As part of the process, you negotiate with your creditors to have your debt reduced by 50% down to $25,000. Thus, you’ve saved $25,000. Because you have filed for bankruptcy, that amount is not considered taxable income.

ndividuals who are considered insolvent are also exempt from paying taxes on debt reduction. You are insolvent if your liability exceeds your total assets, meaning you owe more than you own.

What you can do

Unless you fall under one of the three exemption rules, there is not much you can do about the tax liability. You cannot cheat the IRS. Your creditors will have reported the forgiven debt on your behalf. You will have to include the full amount in your annual tax return.

The most important thing you can do is plan for the tax charge in advance. Calculate the amount you are likely to owe to the IRS based on your tax bracket. In some cases, the extra “income” may push an individual into a higher tax bracket, so he will owe more. Once you know the tax amount, factor it into your financial planning, including the negotiation with your creditors.

Debt settlement money as taxable income

When is it not considered taxable income?

What you can do

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