If you have missed payments on a credit card debt, or you anticipate a financial change that will prevent you from making your credit card payments on time, you may consider negotiating a settlement with your lender. A settlement is an agreement between you and the creditor in which you pay a portion of the debt, typically in a lump sum, in exchange for the creditor considering the debt paid in full. However, you should be aware of tax issues regarding credit card settlements.
Taxes on Settlements
When you settle a credit card debt with your lender, you may be subject to federal taxes on the forgiven portion of your debt. The Internal Revenue Service considers forgiven debt to be earned income, and it requires you to pay taxes on canceled debt of $600 or more. However, you do not have to pay taxes on the settlement if the forgiven amount is less than $600.
Tax Rate
Because debt forgiven under a settlement agreement is considered earned income, it is taxed at the standard tax rate for your income bracket. Before you agree to a settlement, you should consider the tax bracket into which you taxable income falls. If your income puts you near the top of your income bracket, earned income from debt forgiveness may place you in a higher bracket. This means that you will pay a higher tax rate on any income that exceeds that tax bracket theshold. For example, if your income places you $2,000 below the limit for a tax bracket, and you negotiate a settlement that forgives $5,000 of debt, $3,000 will be taxed at the next higher tax rate.
Settlement Tax Exemption
The IRS provides an exemption from taxation on forgiven debt under limited circumstances. If you are insolvent -- that is, the total amount of your debts exceed the total value of your assets -- you may be exempt from paying taxes on the portion of a credit card balance forgiven under a settlement agreement. However, you must complete and file IRS form 982 with your tax return if you seek this exemption.
Considerations
Although you may be subject to taxation on forgiven credit card debt as part of a settlement agreement, the additional tax liability typically is more than offset by the financial benefits you receive from the settlement. A settlement can free part of your income to apply to other credit card or loan balances, allowing you to pay down your debt more quickly. If you are behind on your debt payments, a settlement may help you avoid bankruptcy, lawsuits, wage and bank garnishments and property liens.
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