If I enroll into a Debt Negotiation program to settle my debts with my creditors, will I have to pay tax to the IRS?
This is a daily question I am asked during my consultations with consumers. The answer is that it depends on your situation. Before I review a few situations to illustrate when you may or may not be required to pay a tax on forgiven debt, let me make it very clear that I am NOT a Tax Attorney and I cannot give you specific tax advice. Please first verify everything with your personal tax professional.
The question about paying taxes on a forgiven debt revolves around a creditor issuing a form 1099-C for a cancellation of a Debt. Say you owe $10,000 and are unable to pay the entire balance. The creditor agrees to accept $5,000 as payment in full and offers a Debt Reduction of $5,000. The creditor then may issue you a 1099-C showing that you had $5,000 of debt forgiven that may be reported by you as taxable income. Think about it like this. Normally when you borrow money you do not pay tax on it because you have to pay the money back. It is not income. However, if you do not pay the money back, then it is essentially a gift which then could become taxable to you.
A lot of consumers have some unjustified fears about this potential tax ramification of Debt Negotiation. First let me make it clear from a financial standpoint, that paying taxes on an amount of debt that is forgiven is always cheaper than paying back the entire debt plus interest. For instance, if a creditor forgave a $9,000 debt, you may have to pay $3,000 or so to the IRS depending on your situation. Isn’t $3,000 cheaper than $9,000 plus interest? So even if you found yourself in a circumstance where you had a tax liability, you are still saving quite a bit of money.
Lets now examine when you may or may not have a tax liability when you have consumer debt forgiven by a creditor.
The Insolvency Rule (IRS publication 908)
Most Debtors find that there is actually a big “loop hole” called the insolvency rule that allows them to NOT have to pay any taxes on the forgiven debt. According to the IRS, if you are “insolvent” at the time of the debt forgiveness, (which most consumers are if they are enrolled in a debt negotiation program) then you have no tax liability on the debt reduction up to the point that you are insolvent.
Let me put that in English for everyone. If your debts outweigh your assets then you are insolvent. So if you have a negative net worth then the IRS lets you slide and does not require you to pay taxes on the forgiven debt. As an example, if you where 100K upside down on your house, had 50K in credit card debt and only 40K in assets then you would be insolvent by 110K and you would not have to pay taxes on any of the settled credit card debt..
Most consumers find that if they are so far upside down financially that they have to look into a debt negotiation strategy, that they are also insolvent and therefore not liable for additional taxes on the amount of debt forgiven. As always though, check with a qualified Tax consultant about your specific situation, and ask if the Insolvency Rules would apply to you.
For further information please see IRS Publication 4681. It covers rules and applications of canceled debts in detail and provides a form to help determine whether or not you qualify under the IRS Insolvency Rules.