Does Settling Debt Affect Your Taxes?

Settling a debt can be an effective way to eliminate a monthly payment without paying the full balance of your loan account. If you have fallen behind on a debt payment, your creditor may accept a lump some payment for a portion of your loan balance. This eliminates the lender's risk of your default, which can lead to costly collection efforts. Although debt settlement can help you eliminate a debt obligation, it may affect your tax liability.

Earned Income

Because a debt settlement means that you have been enriched without repayment -- that is, you have received money or purchased items for which you have not paid -- the Internal Revenue Service considers the forgiven portion of your debt as earned income. This means that you must pay taxes on the difference between the settlement amount and the total amount of the loan. The lender will provide the IRS with form 1099-C, which shows the amount of debt erased pursuant to a settlement agreement. You will also receive a copy of this form.

Tax Rate

Because debt forgiven under a debt settlement is considered earned income, this amount is taxed at the standard income tax rate for your income bracket. However, if you negotiate a settlement for a large debt for substantially less than you owe, the forgiven amount may raise your earned income enough to place you in a higher tax bracket. This can affect not only the tax percentage you pay on the forgiven debt, but also on your wages and other income.

Exception

If you negotiate a debt settlement that results in forgiveness of less than $600 of debt, you do not have to pay taxes on the forgiven amount. However, the creditor will still issue a 1099-C form to both you and the IRS. You must also still report the settlement balance on your tax return as earned income.

Considerations

A debt settlement may affect your credit as well as your tax liability. Your creditor will report your debt as settlement for less than the full balance to credit bureaus, which can lower your credit score. The impact of a debt settlement on your credit depends on how severely other negative entries, such as delinquent accounts, have already affected your credit score. If you have a clean credit history, a settlement will cause more damage to your creditworthiness than if you have already fallen behind on your debt payments.