Do You Claim a Settled Credit Card on Taxes?

Potentially higher income tax bills are one disadvantage of debt settlement. The Internal Revenue Service requires listing of credit card settlement on income tax returns---if the settlement is for $600 or more. The IRS treats savings through debt settlement as income. Credit card companies send documentation about the settlement to the taxpayer and the IRS.

Form 1099-C

People settling debts for at least $600 receive a form from the IRS called "IRS Form 1099-C: Cancellation of Debt." Creditors send the form to debtors in January of each year and to the IRS in February. Forms are sent after the creditor takes a tax write-off on all or part of the debt.

Significance

Debt settlement allows debtors to pay unsecured debts such as credit cards for less than the full balance. It is possible, in some cases, to pay a $10,000 credit card bill for $5,000. That is a significant savings---but it may force the taxpayer to increase his gross income by $5,000 for the year for tax reporting purposes. The amount show in Box 2 of the 1099-C is the amount taxpayers list on tax returns as additional income. SmartMoney reports that creditors often settle credit card debts for 20 to 70 percent of the balance.

Exceptions

People who were insolvent at the time of the settlement do not have to claim the savings on their tax returns. Insolvency means the debtors had more debts than assets. People with lots of credit card debt and few expensive assets such as real estate often qualify as insolvent. People who wish to claim insolvency must attach a detailed letter to the IRS listing debts or assets, or include IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness.

Planning

Debtors engaging in extensive debt settlement should manage the process to avoid tax problems. For example, settling debts early in the year is preferable for tax purposes than settling late in the year. A debt settled in January will not become a tax issue until returns are due 15 months later. However, a debt settlement in November could result in a higher tax bill five months later. Debtors should ask creditors if they plan to report the settlement to the IRS and issue a 1099-C. That allows the debtor to expect the form. However, the IRS reports that the taxpayer should report the savings even if the creditor fails to issue a 1099-C.