Chances are, you don't set out to intentionally default on your mortgage or credit card. When it does happen, dealing with collectors and a damaged credit score can be stressful and embarrassing. In some instances, though, you can negotiate with your creditors to have a substantial portion of your debt forgiven.
While this might seem like an advantageous solution to your financial predicament, there are taxable consequences you'll need to plan for. Unfortunately, your lender or bank won't always explain these details when agreeing to reduce your debt. Before you accept any debt settlement offer, take a close look at what it's going to cost you when you file your taxes.
Why You're Taxed
Debt reduction - as far as the IRS is concerned - is tantamount to income earned. For example, let's say that your credit card company forgives $3000 of your debt if you pay the remainder, as part of a settlement agreement. This $3000 represents goods and services for which you took possession and now no longer have to pay back.
You have realized a financial gain, since you essentially received $3000 worth of merchandise or services for free. This amount is considered income, for which you are now responsible for paying taxes on. In the event that you have settlement agreements with multiple creditors, you will be taxed accordingly on each denomination that was forgiven.
What to Expect
Around the same time you're receiving your annual wage statements from your employer(s), which allow you to prepare your tax return, you will receive 1099's from any creditor that has forgiven a debt. These statements detail precisely how much was reduced, which you are required to report as income on your return. Since settlement amounts can be substantial when added to your regular income, you can be subject to a tax liability far greater than what you're accustomed to paying.
Failure to Report
It's important to keep track of any settlement agreement and the resulting 1099's that are sent. Your creditors, much like your employers, report these reduction events to the IRS. If you do not include matching information on your tax return, the IRS will detect the discrepancy and send you a bill for the difference. This failure to report will lead to penalties and interest, which will only inflate what's already owed.
Errors and Omissions
Since creditor and bank reporting is not infallible, it's critical to pay close attention to any statements you receive regarding a forgiven debt. If a lender erroneously reports to the IRS that your debt was reduced, you'll be held liable for taxes you don't actually owe. If you do receive a 1099 that was sent by mistake, you'll want to contact your creditor immediately to straighten the issue out.
Similarly, if you know that a debt was forgiven but don't receive a 1099, this needs to be corrected at once. While it might seem like you caught a break, the creditor will eventually realize the mistake and update their records. This can create complications for you down the road which can be far less desirable than if you had simply paid the applicable tax on time.
Resolving That Tax Bill
Given your financial circumstances, you may be ill-prepared to pay a tax bill created by a forgiven debt. If this is the case, it's in your best interest to seek assistance from licensed tax professional. You'll be presented with an affordable resolution for your new liability; one that is acceptable to Uncle Sam. For while the IRS won't necessarily forgive a tax debt, they will allow you to handle it in a way that suits your financial means.