Debt Settlement Tax Avoidance - How Will Debt Settlement Affect My Taxes?

If I settle my credit card debt, how will these significant savings affect my taxes?

This is an interesting question when considering how to get out of debt.

In general, the IRS considers $600 or more of debt which is forgiven or discharged as income. This mean if you owe $50,000 in credit card debt and settle it for $20,000, then the $30,000 difference (savings) is taxable as income since it is not repaid. Although it doesn't always happen, the forgiving creditor must provide the taxpayer with a 1099-C tax form.

However, the IRS will often waive this tax liability if you can show you were insolvent during the time in which your debt settlement took place. To take advantage of this exemption from tax liability due to the discharge (settlement) of debt, file Form 982 with your taxes for the years in which you settle your debts. You can find this form online at irs.gov.

It is highly recommended that you make a quick call to your accountant or tax professional for further discussion. You may be relieved with what they have to say.

What Does "Insolvent" Mean?

Being insolvent means the amount of your debts are greater than your assets (how much money and property you own).

For example, if a taxpayer has $50,000 in debt and owns $30,000 in assets, he/she cannot exclude more than $20,000 of forgiven debt from his/her income tax. Any forgiven debt over $20,000 that year must be reported as taxable income.

EXAMPLE STORY OF DEBT SETTLEMENT TAX AVOIDANCE:

Tom Smith experienced a financial hardship; losing his job for several months and falling behind with his creditors. When he resumed working, his new job could only offer him a reduced income. After falling behind, Tom's interest rates on his credit card debt jumped up to an average over 20%. His minimum payments jumped up as well and he was no longer to keep up even after he began working again.

Tom was able to avoid declaring bankruptcy by reaching an agreement with his creditors, whereby they agreed to forgive $20,000 of the total he owed them.

At the time of the debt settlement, Tom's liabilities totaled $120,000 and the fair market value of his assets was $100,000. At the time Tom settled his debt, he was considered insolvent by $20,000. So Tom was able to exclude the entire $20,000 of credit card debt that forgiven from his taxable income because it was not more than the amount by which he was insolvent.

What's the Bottom Line on Paying Taxes for the Money You Save from Debt Settlement?

To the degree you are insolvent (your debts are greater than assets) at the time your debt is settled, you can be exempt from income tax due to the forgiveness or discharge (settlement) of credit card or unsecured debt by filing IRS Form 982 along with your taxes. However, the IRS adds "you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent."

There are always very clear and real responsibilities when dealing with credit card debt, especially when you don't pay back 100% of what you owe through debt settlement. However, once you can remove your credit card debt problem from your life, a whole new world of opportunity can open up for you as you finally become debt free.