How Does Debt Settlement Affect My Taxes?

How Does Debt Settlement Affect My Taxes?

In order to understand how debt settlement can affect your taxes, the first step is to understand the debt settlement process. Debt settlement is sometimes referred to debt negotiation because the consumer, or someone on his or her behalf, is negotiating a lower sum that the creditor will accept in full payment of the entire balance on the account.

Some individuals work directly with the creditor to agree to a debt settlement while other may use a debt settlement service or debt settlement law firm. Regardless of who negotiates the debt settlement with your creditor, you need dot understand how a debt settlement will affect your income tax return for the year of the settlement.

Debt Settlements and Tax Returns

In almost all cases, a debt settlement will be considered “income” by the Internal Revenue Service.  When you settle a debt with a creditor, the creditor “cancels” the remaining balance.  For example, if you owe $20,000 on a credit card account and you settle the account for $9,000, the remaining balance of $11,000 is cancelled by the credit card company meaning the company will no longer pursue you for this debt.

However, the credit card company is required to report this cancelled debt to the Internal Revenue Service on a 1099-C form.  The credit card company sends the original 1099-C to the IRS and you receive a duplicate original for your records.  At the end of the tax year when you prepare your taxes, you must include this amount as “income” on your tax return and pay taxes on this “income.”

The effect on your taxes depends on your specific financial situation.  For someone who typically receives a large tax refund each year, the debt settlement could wipe out the tax refund completely or substantially reduce the amount.  For other taxpayers who break even each year, the addition of income often results in the person owing taxes for that year.

In some cases, the IRS may waive the tax liability if you can prove that you were insolvent when you settled the debt.  Therefore, you should consult a tax professional before filing your own tax return if you have received a 1099-C and are unsure how the debt settlement will affect your taxes.

Another option some individuals pursue as an alternative to debt settlement is bankruptcy.  If you file bankruptcy, the discharged amounts will not be reported to the IRS as income and you will not be required to pay taxes on this debt.  Consulting an experienced bankruptcy attorney or debt settlement attorney prior to making any decisions regarding debt settlement is in your best interest.

Using a Debt Settlement Company to Negotiate My Debts

As stated above, some individuals hire debt settlement companies to hand the debt settlement negotiations with their creditors.  You must be careful when dealing with some of the companies because they can charge large fees for their service.  Furthermore, your creditors are not required to work with these companies and many creditors do not work with debt settlement companies that have bad reputations.  If you hire anyone to help you settle debts, make sure you are hiring a law firm with licensed attorneys.

Are You Considering a Debt Settlement or Bankruptcy?

If your creditor is pushing a debt settlement, you need to discuss the advantages of disadvantages of settling this debt prior to entering a debt settlement agreement.

Weston Legal PLLC can answer your questions if you have been sued for debt, have judgments or other concerns. Contact us at 800-220-4318.

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