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Debt Settlement & Income Taxes – What You Need To Know
By: Charles Phelan
Debt settlement has become a popular approach to resolving problem debts without
having to file bankruptcy. With this approach, creditors agree to accept a
portion of what you owe (usually around 50% or less) to settle the account, and
the remaining balance is forgiven. This technique will certainly continue to
grow in popularity now that the new bankruptcy law makes it tougher to fully
discharge debts in a Chapter 7 bankruptcy.
As with anything, there is no free lunch, and creditors are required to report
canceled debts to the IRS on Form 1099 (when the canceled balance is $600 or
greater). Therefore, the possibility exists that you may owe taxes on the
forgiven portion of the debt. For this reason, many financial writers and debt
counselors are strongly critical of debt settlement, to the point where they
actually recommend against it just because you might end up owing taxes. But the
tax consequences of settling your debts are greatly over-emphasized, and this is
a really just a minor issue at best.
First, even if you end up owing taxes on the canceled balances, that's because
you saved a bunch of money off your original debts. The total of what you paid
the creditor, plus the taxes, will still be much less than what you owed to
begin with. There is still a net savings. So it's hard to understand why this is
viewed as a problem in the first place!
Second, the great majority of people who settle their debts are not required to
pay taxes on the forgiven part of the balance. That's because of the
"insolvency" rule, described in IRS Publication 908, "Bankruptcy Tax Guide."
Don't let the title fool you. You don't need to have filed a formal declaration
of bankruptcy to take advantage of the insolvency rule.
Basically, "insolvent" means that you have a negative net worth -- that is, you
"owe" more than you "own." As a consequence, most debtors do not have a tax
liability on the canceled debts, simply because most debtors are insolvent! It
usually comes down to home equity. If you have enough equity in a home (or other
property) to outweigh the total of your liabilities (debts), then you have a
positive net worth, and will likely have to pay taxes on the forgiven debt
amounts. However, the majority of people in serious debt trouble have a negative
net worth, and are therefore insolvent. The way it works is that you can offset
the canceled debt up to the amount by which you were insolvent at the time you
did the settlement.
Come tax time, be sure to get professional tax advice specific to your
situation. Also, be sure to read the section in IRS Publication 908 on
"reduction of tax attributes," which requires people using the insolvency rule
to reduce their basis in such things as rental property, loss carryovers, etc.
Most of that probably won't apply to you, but again, get specific advice before
winging it.
So, the message is, relax about paying taxes on canceled debt balances. That
should be the least of your concerns if you're upside down financially. Don't
let the misguided criticisms of financial writers (who haven't done their
homework) discourage you from looking into one of the most popular and flexible
options for achieving debt-freedom.
About the Author:
Charles J. Phelan has been helping people become debt-free without bankruptcy
since 1997. A former executive in the debt settlement industry, he teaches the
do-it-yourself method of debt negotiation. Audio-CD material plus expert
personal coaching helps consumers achieve professional results at a fraction of
the cost.
www.zipdebt.com
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