The concept, although quite simple, can actually be very confusing for consumers, especially because of false information offered by some debt relief sales people.
The bottom line: Unless exempted by the insolvency rules or another exemption, you will owe taxes on debt that has been forgiven by a creditor. In this article I assume that none of the exemptions apply.
Some of my clients have expressed an attitude of distaste that after finally getting out from under a crushing debt load, they were hit with a tax bill on that forgiven debt. They felt it was a bit unfair and perhaps a little mean spirited by good old Uncle Sam. The aim of this article is not an attempt at a justification either for or against taxing a consumer on a forgiven debt, but simply an explanation to show why everyone’s favorite uncle expects you to pay up when your former lender lets you off the hook.
Why must I pay Taxes on Debt Settlement?
The best way to illustrate this is with an example. You borrow $10,000 from a bank and promise to pay it back with interest. You pay no taxes on that $10,000 because it is a loan and not income. Now your business gets hit hard by the economic downturn and you are no longer able to keep up on your monthly payments. After falling behind several months, the bank offers to accept $5,000 as payment in full and forgive the additional $5,000 that you owed. You accept the deal and receive a 1099-C the following January for $5,000. Why?
When the bank agrees not to collect the additional $5,000 from you, it is going to write it off on their taxes as a loss. This means that that bank will be able to earn $5,000 in tax free income, essentially because it gave the money to you. So if the IRS can’t collect that income from the bank, they are going to go looking to collect it from the person that let the bank off the hook for it.
When you first took out the loan, the money was not taxable because you were going to pay it back. Now that you have been given $5,000 by the bank and no longer have to pay it back, it is no different then getting a second job and earning $5,000 and you would naturally have to pay taxes on that income.
So Uncle Sam is not coming after consumers simply to kick them while they are down. The IRS is simply collecting tax on $5,000 dollars in income that you received from the bank.
To Avoid Taxes on a Debt Settlement should I just never Settle a Debt?
As much as people usually cringe at the thought owing money to the IRS, the decision to attempt to settle a debt with the creditor should not be based solely on whether or not the settlement will result in a tax liability. I am quick to point out to my clients who find taxes on debt settlement to be unfair, that paying taxes on $5,000 dollars will cost them a lot less money then paying the $5,000 in full plus interest over several years.
If you can afford to pay your debts then you should of course pay them. However, if your financial situation has reached a point where you need to look at some drastic options, debt settlement is a good idea to consider. The fact that you may or may not owe taxes on a debt settlement is something that needs to be considered but really only to the extent that the economics of the settlement will still make sense and that you have the funds to pay the taxes when they are due.