Debt Settlement & Income Taxes – What you ought to Know
Debt settlement has become a well-known method of solving problem debts without having to file bankruptcy. With this strategy, creditors consent to accept a portion of what you owe (usually around 50% or less) to pay the account, and the remaining balance is pardoned. This technique will certainly keep growing in popularity now that the new bankruptcy law makes it tougher to fully discharge debts in a Chapter 7 bankruptcy.
As with anything, there is absolutely no free lunch, and creditors are required to report terminated debts to the IRS on Form 1099 (when the canceled balance is $600 or greater). Therefore, the possibility exists that you may owe taxes
on the forgiven part of the debt. Because of this, numerous financial writers and debt counselors are strongly critical of debt settlement, to the point where they really recommend against it just because you might end up owing
taxes. But the tax consequences of settling your debts are tremendously over-emphasized, and this is a really just a small issue at best.
First, even if you end up owing taxes on the canceled balances, that is because you saved a bunch of money off your original debts. The total of what you paid the creditor, as well as the taxes, will still be much less than what you owed to begin with. There is still a net savings. So it’s difficult to understand why this is seen as a problem from the start!
Second, almost all of people who work out their debts are not needed to pay taxes on the forgiven part of the balance. That is because of the “insolvency” rule, described in IRS Publication 908, “Bankruptcy Tax Guide.” Don’t allow the
title trick you. You don’t need to have filed a formal declaration of bankruptcy to take benefit of the insolvency rule.
Basically, “insolvent” means that you have a negative value — that is, you “owe” more than you “own.” As a consequence, most debtors don’t have a tax liability on the canceled debts, simply because many debtors are insolvent! It usually comes down to home equity. If you have sufficient equity in a home (or other property) to outweigh the total of your liabilities (debts), then you have a positive net worth, and will likely have to pay taxes on the forgiven debt amounts.
Nevertheless, the majority of people in serious debt trouble have a negative net worth, and are therefore insolvent. The way it works is that you can counterbalance the canceled debt up to the amount by which you were insolvent at the time you did the settlement.
Come tax time, be sure to get professional tax advice specific to your situation. Furthermore, make sure to read the section in IRS Publication 908 on “reduction of tax attributes,” which requires people using the insolvency rule to reduce their basis in such things as rental property, loss carryovers, etc. Most of that probably will not apply to you, however, get specific advice before winging it.
Thus, the message is, relax about paying taxes on canceled debt balances. That should be the very least of your concerns if you’re upside down financially. Don’t allow the illinformed criticisms of financial writers (who haven’t done their homework) discourage you from looking into one of the most well-known and versatile alternatives for attaining debt-freedom.