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Understanding Debt Settlement and Its Tax Implications

Do you pay taxes on settled debt? It’s a question more people may be asking as credit card balances continue to grow. According to the Federal Reserve Bank of New York, credit card balances increased to $1.08 trillion in the third quarter of 2023, and delinquencies are on the rise. As credit card balances become increasingly difficult to pay down, people may turn to debt settlement for relief.

How Debt Settlement Works

Debt settlement involves negotiating with your creditors to accept less than what you owe. You might be able to work directly with your creditors to reach an agreement. Although creditors prefer full repayment, they may negotiate to avoid sending your debt to collections or help you avoid bankruptcy.

Alternatively, you can work with a debt settlement company that negotiates on your behalf. However, this approach carries risks. Some debt relief companies may use tactics that damage your credit. Additionally, any reduction in the amount you owe is likely to be considered income by the IRS, and you may have to pay fees to the debt settlement company.

Tax Implications of Debt Settlement

The IRS considers canceled or forgiven debt as income, similar to wages or interest earned on a bank account. For example, if you settled $5,000 in credit card debt for $1,500, the IRS would count the $3,500 in debt forgiveness as part of your income.

If a creditor forgives $600 or more in debt, they will issue a Form 1099-C showing the amount of debt canceled. This form is sent to both you and the IRS, so you must report the canceled debt on your tax return. Failure to do so may result in the IRS contacting you about the discrepancy.

How to Report Canceled Debt

You’ll report the canceled debt amount on your federal tax return using Schedule 1: Adjustments to Income and Additional Income. Enter the total amount of canceled debt for the tax year on line 8c, then report your total Schedule 1 income on line 8 (“other income”) of your federal tax return, Form 1040. Add your canceled debt amount to your wages, interest earnings, and other taxable income.

Tax Rate on Settled Debt

Settled debt is taxed as ordinary income. The amount you’ll pay is based on your tax bracket and marginal tax rate. For instance, if you earn $75,000 a year as a single taxpayer, your top marginal tax rate is 22%, so any additional income from a settled debt will be taxed at 22%.

Determining Tax Liability from Debt Settlement

Keep records of any settled debt to help you calculate how much debt was canceled for tax purposes. Match your calculations against the canceled debt reported on any 1099-C forms issued by your creditors.

If you had a debt of less than $600 forgiven, you might not receive a 1099-C. However, you should still report the canceled debt on your tax return, as any canceled debt is considered taxable.

Exceptions to Canceled Debt

The IRS makes exceptions for some canceled debts. If any of the following scenarios apply to you, your debt forgiveness is not considered taxable:

• Debts canceled as gifts, bequests, or inheritances
• Qualified student loans with cancellation provisions based on employment in certain professions
• Some student loan discharges made between December 31, 2020, and January 1, 2026
• Amounts received or forgiven under certain student loan repayment assistance programs
• Amounts of canceled debt that would be deductible if paid as a cash basis taxpayer
• A qualified purchase price reduction given by the seller of property to a buyer

Excludable Debts

The following settled debts don’t have to be included in your taxable income, even though the IRS considers them canceled debts:

• Debt canceled in a Title 11 bankruptcy case
• Debt canceled due to insolvency
• Qualified farm indebtedness
• Qualified real property business indebtedness
• Qualified principal residence indebtedness discharged before January 1, 2026

The Bottom Line

Although it’s straightforward to account for settled debt on your tax return and pay the resulting taxes, it may be better to consider your tax bill early in the debt settlement process, preferably before signing an agreement. If meeting your debt obligations is difficult, paying taxes on settled debt might be too.

You can estimate how much canceled debt you’ve accumulated and how much tax you might owe based on your 2024 tax bracket and marginal tax rate. If you need help, consider meeting with a tax professional who can assist with calculations and planning for additional taxes. If you can’t afford to pay your tax bill, you may be able to apply for tax debt relief or arrange a payment plan with the IRS.

If you’ve recently settled debt, you may also want to check your credit. Debt settlement can affect your credit, often negatively. Checking your credit score for free with Experian can help you understand the impact and consider ways to rebuild your credit over time.

For any mortgage-related needs, feel free to call O1ne Mortgage at 213-732-3074. We’re here to help you navigate your financial journey with confidence.

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