Do Credit Card Settlements Affect Your Tax Returns?

Credit card settlements occur when a debtor arranges to pay a card off for less than the full balance. The process is the same as debt settlement and results in major savings for the debtor. Credit card companies sometimes settle delinquent credit card accounts for as much as 70 to 75 percent of the balance. Settling may have a significant effect on tax returns, however.

Considerations

The Internal Revenue Service treats savings from credit card settlement as income, as of the time of publication. That means a person settling $5,000 in credit card debt for $1,500 for example, must report $3,500 in additional income to the IRS. That could lead to a higher tax bill and wipe out a portion of the savings from the settlement. It could create other problems, as well, if the debtor cannot afford to pay the higher tax bill, or does not receive a special exception from the IRS for avoiding a penalty for debt settlement.

Process

Federal law requires credit card companies to notify the IRS when a person completes a settlement agreement that eliminates at least $600 in the transaction. The card companies also send a 1099-C tax form listing details of the transaction and the amount the debtor must report to the IRS as income. The IRS maintains the debtor is responsible for reporting the income, even if the credit card company fails to issue a 1099.

Exception

There is one way to avoid a higher tax bill for a credit card settlement. The IRS allows exceptions for people who were insolvent at the time of their settlement. Insolvency means a person has more debts than assets. People who do not own real estate or other expensive assets may qualify for insolvency. Others may qualify as well, including people whose real estate or other assets have significantly dropped in value. IRS form 982, "Reduction of Tax Attributes Due to Discharge of Indebtedness," allows people settling debts to apply for insolvencyl.

Timing

People who do not qualify for insolvency should settle credit card debt early in the year. Settling in December means paying the higher tax bill in four months, in April. Settling in January gives the debtor 15 months -- until April of the following year -- to plan for the tax consequences.

State and Local

Taxpayers should contact their tax adviser for guidance on possible state or local tax liabilities from debt settlement. In 43 states, as well as some municipalities, residents must report income for tax purposes.