If you have ever done a debt settlement or used a debt negotiation program, it is possible that you received a letter about the tax consequences of debt cancellation or debt forgiveness. For those not familiar, debt settlement, also known as debt reduction, involves negotiating with creditors (normally credit card companies) to reduce your principal balance.

If you have ever done a debt settlement or used a debt negotiation program, it is possible that you received a letter about the tax consequences of debt cancellation or debt forgiveness. For those not familiar, debt settlement, also known as debt reduction, involves negotiating with creditors (normally credit card companies) to reduce your principal balance. In some cases, a consumer can eliminate up to 50% of their balance, saving them thousands of dollars and getting them out of debt fast without filing bankruptcy. One of the downsides of this type of debt plan, however, is that there can be potential tax liabilities associated with having your debt forgiven.

(The following is for educational purposes only and does not constitute tax or legal advice. PayingPaul.Com makes no guarantees about the accuracy of anything included below. For tax or legal advice, please consult a licensed attorney, lawyer, or CPA).

Debt Forgiveness Form Questions

Under what circumstances will someone receive a 1099-C for a cancelled debt?

Normally a 1099-C letter is issued when two conditions are met:

a) a credit card company forgave part or all of a debt and

b) the debt’s balance was greater than $600.

What is the purpose of this?

It is the creditor’s way of telling the IRS that it was a bad debt and they should be able to charge off or write off the account as a loss on their taxes. Since part of the debt is considered a loss on the credit card company’s income statement, you are now responsible to pay taxes on the cancelled portion of the balance. The letter is the creditor’s way of notifying you that you are responsible to report the forgiven portion of the balance as income on your tax returns.

I don’t understand this. What exactly will I be responsible for paying taxes on?

Perhaps an example will better illustrate what exactly happens. Let’s assume that you owed $10,000 on a credit card debt. Company you work with settled the total balance for $3,000. In this instance, you would be responsible for paying taxes on the difference: $7,000.

So I would owe $7,000?

No. You would need to report this as income on your tax returns. In other words, if your income is $50,000, it is now $57,000 because of the cancelled debt.

Are there any circumstances when I won’t have to pay any taxes?

Yes. If you were insolvent (your liabilities or debts exceed your assets) at the time the debt was forgiven, you do not have to pay taxes on the cancelled portion. You will still, however, need to report it on your tax returns, but if you attach a letter or IRS form 982 detailing your assets and income (and that you were in fact insolvent, course), then the IRS won’t hold you liable for paying taxes on it.

Will I have to pay taxes on any forgiven balances if I filed personal bankruptcy?

No.

Should I be concerned about settling my debts because of this fact?

Generally people who should be considering debt negotiation are in a financial hardship and are overextended to the point that bankruptcy is their only realistic hope of getting out of debt other than debt settlement. This being the case, many consumers who are in fact considering negotiating their debts are insolvent. After all, if they had a lot of assets to pay off the debt they would do that in the first place. Secondly, even if you are expected to pay taxes on the debt, you are only paying a percentage on the savings, so it is still likely you will come out ahead. Of course, this is likely something you would want to talk with a tax professional before moving forward.