Tax Consequences for Debt Reduction

Negotiating with your creditor to reduce your debt could save you thousands of dollars in interest and debt payments. While this strategy can be beneficial, it could also lead to an unexpected tax liability. When a creditor allows you to reduce your debt, the Internal Revenue Service could send you a bill.

Debt Reduction

The idea behind debt reduction is that a creditor reduces your account balance in exchange for a lump sum payment. With this option, you negotiate with the creditor to take less than what you owe. The creditor takes the payment and then cancels the remainder of the debt. Many creditors will settle for 50 percent or less compared to what you owe. Debt reduction can also show up on your credit report and negatively impact your credit score.

Earned Income

When you go through a debt settlement, it results in spending less money on paying back your creditor. In the eyes of the IRS, it appears as if you made more money for the year. When a creditor forgives a debt, this will be reported to the IRS. The IRS will expect you to count the amount that was forgiven as part of your taxable income. This means that you must pay taxes on the amount forgiven and it could put you in a different tax bracket.

Handling the Taxes

At the beginning of the following year after the debt was forgiven, the creditor will send you a tax document in the mail if the amount forgiven was greater than $600. The document you will receive is a 1099-C cancellation of debt form. On this form, you will find the total amount that was forgiven. When you prepare your tax return, you will give this form to your tax preparer or enter the amount shown on your return documents. It will then be added to your annual income, and taxes will be calculated based on that number.

Considerations

With the tax burden in mind, debt settlement may not be the attractive deal that you thought it was. If you use a debt settlement company to handle this process for you, it can minimize the benefit of debt reduction in the first place. Between the fees you pay to the debt settlement company and the tax burden, you may not actually save that much money. When you factor in the credit score hit that you will receive as a result, you may be better off exploring other options.