Paying Tax on Settled Debts
I am not a tax professional, and if you have a complicated financial portfolio, it would be best if you contact your accountant or a tax professional, but here is the low-down.
When you enter into a debt settlement program, the intent is to get you out of debt for the least amount of money in the shortest amount of time so you can get a fresh start, no matter the cost!
When a creditor or collection agency negotiates the balance that you owe them to a lesser amount, and agrees that it will be considered as payment in full, the creditors are taking a loss. Because of this, the creditor will file the unpaid or ‘forgiven’ portion of your debt on their taxes as bad debt. This will generate a 1099C form in your name.
This action by the creditor is a law. It is not a sometimes thing, and there can be stiff penalties for companies that don’t comply. A 1099C form will be sent to you (or whatever address your original creditor has) and you must file it with your next years tax return, claiming it as income earned. Just because you don’t get it does not forgive the fact that you must file it.
Offsetting the Tax of a Debt Settlement
That being said, there is another form, an IRS form #982 which is called ‘A Forgiveness of Tax Attributes Due to Indebtedness”. This form will allow an individual to offset the ‘income’ from the debt that was forgiven… AS LONG AS YOUR TOTAL LIABILITIES EXCEED THE FAIR MARKET VALUE OF YOUR ASSETS AT THE TIME OF THE DISCHARGED DEBT.
Again, I am not a tax professional, but here is an example:
The fair Market Value of your assets is $95,000 (you own a house with $95,000 worth of equity). Who has that right now, right? But, let’s pretend.
OK… you have $95,000 in assets, and your total liabilities (what you owe on everything else) adds up to $100,000… Let’s just say that your liabilities (what you owe) includes a $20,000 Credit Card Debt. This means you are insolvent (your liabilities outweigh your assets) to the tune of $5,000. So… if your $20,000 credit card was settled for $8,000, that means $12,000 was forgiven. Since you are insolvent only $5,000, then only $5,000 of the $12,000 cacellation of debt is NOT taxable. This means that you will be taxed, in your individual tax bracket, on the remaining amount above the $5,000… you will be taxed on the remaining $7,000. If you are in a 28% tax bracket, the IRS would require you to pay $1,960. Again, consult an accountant or tax professional.
In the end, the amount that you pay is stilll a heck of a lot better than the amount you originally owed, and were struggling to pay, and you could certainly (in most instances) go on a payment plan with IRS because without your credit card debt you can now afford to do that!
If you have no assets, don’t own a house or property, or are completely upsidedown in the house that you are stuck in (common these days), and you owe more on your car than it is worth, etc., then the above example means nothing to you because all you have are liabilities and the taxes can be forgiven.
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