Written by: Amber Westover | Best Company Editorial Team
Last Updated: February 24th, 2020
If you are struggling paying off your debt you may be considering debt settlement. There are many reputable companies that can negotiate with creditors on your behalf. Through this process, it is possible to significantly reduce your debt. However, debt settlement may have notable tax consequences.
The Debt Settlement Process
We already know that taxes can be a huge burden on those who are already struggling financially. Debt settlement is designed to relieve some of the financial burdens you experience apart from taxes.
The debt settlement process usually begins with an evaluation of your financial situation. Through this process, a personal consultant will help you determine if debt settlement is right for you. If not, they may suggest other options such as debt consolidation, a debt management plan, etc.
If debt settlement is the best option, you often begin by making monthly payments to a designated savings account. Then the debt settlement company will negotiate with your creditors. They will use the accumulated lump sum in the negotiation process. Their goal is to get creditors to accept less than you owe.
If successful you could potentially pay less than half of your outstanding debt. Companies such as Pacific Debt have settled debts for 20 to 55 percent of the original balance. This process could potentially save you thousands of dollars. It often takes a few years to pay off all debt.
It is important to note that you will often pay a percentage of either the enrolled or settled debt to the debt settlement company. Fees are typically 20 to 25 percent of the enrolled debt.
Taxes on Cancelled Debt
Unfortunately, paying off your debt may not be the end of your financial worries. Any canceled or forgiven debt is reported to the IRS. Reducing your debt lowers your creditor's income. That income is now attributed to you and is taxable.
Your creditor will fill out a 1099-C form and send it to both you and IRS. This is required for any forgiven debt that exceeds $600. The form includes contact information for you and your creditor, the amount of debt discharged, any applicable interest, and a description of the debt. It also indicates whether or not you were personally liable for the repayment of the debt.
For instance, if you owe $10,000 in credit card debt and negotiate a settlement where you end up paying $6,000, the unpaid $4,000 is taxable as income. The additional taxes incurred by this regulation could easily cause you more debt.
Luckily, there are several tax exclusions to the IRS' canceled debts regulations. According to Publication 4681 the exclusions include insolvency, bankruptcy, and other qualified forms of indebtedness.
Insolvency: You are considered insolvent if your total liabilities exceed the fair market value of all your assets. This only applies if you were insolvent before the debt was canceled. You can assess your insolvency by totaling all your debts and comparing them to all your assets. There are many free online calculators to help you determine if you qualify for this exclusion. You can access one here.
Bankruptcy: Debt canceled in title 11 bankruptcy cases (including chapters 7, 11, and 13) is not counted as income. However, if you are using a debt settlement company you likely did not file for bankruptcy.
Qualified Indebtedness: There are a few other exceptions. These include debt incurred due to farm operation costs, real property used for trade or business, and your principal residence.
Speak with a tax professional to determine if you qualify for one of these exclusions. If you do, you will fill out a 982 form to remove tax liability.
Choosing a Debt Settlement Company
Before entering into a debt settlement agreement, ask your debt settlement company about these tax implications. Discuss your specific situation and determine whether or not you qualify for insolvency. You don't want to pay off your unsecured debt only to find yourself with tax debt.
To determine if debt settlement is right for you, assess your outstanding debt and projected savings. Be sure to include fees and potential taxes. If the savings outweigh the cost then debt settlement may be a great option.
When choosing a debt settlement company make sure they are reputable. Accreditations such with the American Fair Credit Council (AFFC) and International Association of Professional Debt Arbitrators (IAPDA) indicate that the company is using best industry practices. You can also read the Federal Trade Commission's guidelines for debt settlement companies. Check out BestCompany.com's top ranked debt settlement companies and read reviews from real customers to help you make the best choice for your individual circumstance.