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.
Damn Taxman. I had a run in with them several years ago. On my accountants advice I invested some money in a Bruce Willis film. At the time it was perfectly legal, so much so that my bank manager said he was interested in it as well.
The idea of the scheme was not that I would get out of paying the tax, it merely deferred it for several years. The trouble was the taxman decided he didn’t like the plan anymore so he changed the rules and then backdated it catching me an many others in their net.
Not only did I have to pay them back they fined me as well! I didn’t have the money at the time and so I asked if I could pay it off in installments. He asked me if I owned my own home and if so to sell it. Ass. I took out a loan and paid the wanker.
There was a silver lining though. There was a class action taken against the tax department and we won and they had to pay it all back 🙂
Wow Sire,
That is actually a pretty incredible story. I am not as familiar with how the taxman works down under in Austrailia, but sounds awesome that you were able to get the money back.
What you are describing sounds like a total scam. If they want to change the rules, then ok, but to then backdate the rule to catch people that did something when there was no rule, certainly should not be allowed.
I am glad it worked out for you.
Yeah, well I was lucky that there were some bigger players that also got caught in the net that were the backbone of the class action. It’s not often you can win against the tax department.
That’s the problem with government, they work with two sets of rules, one for the and one for everyone else.
Damon, I think your advice to get a settlement coach to help settle out one’s debt is great. From personal experience, I can honestly say that, that was the best decision I ever made. I strongly suggest that any individual in debt take this approach just like I did. In the end, it saves you a lot of money.
Hello Taylor,
Yes, while the approach of negotiating with creditors with the help of an experienced coach is not for everyone, for those that are willing to go this route, it can be a big money saver.
What many consumers do not realize is that creditors will negotiate directly with consumers provided the consumer has the right information and assistance to know when to do what.
Thanks for taking the time to drop by and comment on the article.
You brought up the comparison between paying taxes on a negotiated debt to that of paying taxes on earned wages. Having never been involved in the former scenario (*knock wood*), are all the taxes owed there the same as that owed on taxable wages – e.g., social security, medicare – or are only federal taxes due?
Hey Sonny,
Good question. First let me preface this with I am not a CPA or Tax Attorney so anyone reading this should of course speak with a qualified tax provider before acting on anything.
That being said, assuming you are solvent and cannot qualify to have the tax on the forgiven debt waived, you would treat the 1099 on the forgiven debt the same way you would treat any other 1099.
It would be no different than if you did contract work for a company and they paid you 5,000 dollars and then filed a 1099 for the 5,000 at the end of the year.
Damon,
Do you know when the taxes are to be paid? Do I pay them at the time the debt is forgiven or will this hit me at tax time? If it’s the latter, can I increase my withholding’s from my paychecks so it won’t be so bad when tax time comes? Somebody always has their hand out.
You will want to consult with whoever does your taxes, but typically you will receive a 1099 for the year the debt was forgiven. Then you would include that 1099 as income when you file your taxes for that year, which would typically be around April 15th of the following year.
Of course if you were insolvent at the time of the debt forgiveness then you would apply for essentially a waiver of the tax when you submit your 1099.
So yes if you will owe some additional tax you can increase your withholding from your check if it helps you to plan for it.
What about short sales on a home where the bank allows to have a home sell for less than owed and writes off the difference on a loan. Is that part of the debt settlement tax?
Hello Loraine,
That will depend on the state that you are in as well as if the home is a primary or investment home. It will also depend on federal law at the time. Because of the housing crises, there are quite a bit of state and federal laws that have come out to assist consumers.
The best thing for you to do would be to consult a local real estate or tax attorney about your specific situation. In some cases you could be liable for debt forgiven on a short sale or foreclosure.
Unbelievable. Taxes on debt settlement? Governments and businesses want us to stay in debt so that they can continue to earn ludicrous amounts of money from individuals who can ill afford to pay.
Yup! So, lemme get this straight; I pay what I can afford of my debt to them, and subsidize their tax write-off … yeah, that seems fair – lol!
Yeah, I’m helping my wife finally dig out of some serious debt after the economic downturn of a few yrs. ago and I am absolutely stunned (and livid) after just recently finding this out. Quick question though; is this part of that bankruptcy legislation from a few years ago that the credit card companies essentially wrote and bought from congress, and that our beloved media conveniently failed to warn us about?
This is just another example of taking the tax burden off the wealthy and putting it on the middle class.
Hey Craig,
No is isn’t part of the bankruptcy legislation. Keep in mind, there is a provision that if you are insolvent at the time of the forgiven debt, you can request a waiver of having to pay the taxes due.
I understand it isn’t exciting to get a 1099 for additional taxes when you are struggling to get out of debt. Not going to speak to the fairness of the tax code, but from an analytical standpoint, if a bank gave you 10K, and you only returned 5k of the principle, then you did get 5k tax free. So the tax man will come looking to collect.
Again, I am not getting into the astronomical amount of interest paid for years and things like that, but merely providing an explanation of why they treat that forgiven debt like regular income. It isn’t fun, but debt never is 🙂
How is your situation going? Are you close to having all of your wife’s debt resolved? Remember to check her net worth for solvency, and you may be able to get the potential taxes due waived.