Debt Forgiveness Tax Implications

Debt forgiveness tax implications summary:

• To the IRS, settled or forgiven debts typically count as taxable income. The amounts need to be reported on your federal and state tax returns.

• You might avoid paying taxes on settled debt if you're insolvent. Insolvent means you owe more than you own.

• Consider consulting a tax professional to find out what taxes, if any, you might owe on forgiven debt before you settle a debt.

Debt Forgiveness Tax Implications Definition and Meaning

Debt forgiveness tax implications are the potential financial consequences of settling a debt for less than the full amount you owe. You might owe additional income taxes if you have debt forgiven, discharged, or settled. 

Many types of forgiven debt can be taxed as income and must be included in your annual income tax returns. This is known as Cancellation of Debt (COD) income, and it is reported by the lender to the IRS via a form 1099-C.

Not everyone needs to pay taxes on forgiven debt, and you might avoid it if you're eligible for an exemption.

When Do You Owe Taxes on Forgiven Debt?

Debt forgiven through debt settlement is generally taxable as income. Debt settlement is the process of negotiating with your creditors to get rid of your debt for less than you owe. 

The difference between how much you owe and how much you pay to settle is referred to as forgiven or cancelled. The Cancellation of Debt (COD) income is taxed just like regular income from wages or other earnings.

For example, if you owe $20,000, but negotiate with your creditor to get rid of your debt for $13,000, the creditor agrees to forgive $7,000 of debt. To the IRS, it’s no different from having someone hand you $7,000 in cash. That $7,000 is COD income according to the IRS, and could be taxable.

Key Features: Exemptions to Income Taxes on Forgiven Debt

There are two situations when you might not owe taxes on your forgiven debt:

• The debt was discharged during bankruptcy. You won’t owe income taxes on debts that are forgiven or discharged during bankruptcy proceedings.

• You were insolvent when the debt was forgiven. Insolvent means your assets (the things you own) are worth less than your debts (the amounts you owe). For instance, if you have $50,000 in assets and $70,000 in debt, you’re insolvent by $20,000. The first $20,000 in forgiven debt wouldn’t be taxed. If you receive more than $20,000 in debt forgiveness, the amount above $20,000 could be subject to income taxes. 

Do You Need to Pay State Taxes on Forgiven or Settled Debt?

Potentially, yes. Whether you need to pay state taxes on forgiven debt depends on which state you live in, as well as your individual financial circumstances. Check the rules for your state and consult with a tax professional to find out if you owe state taxes on forgiven debt. It’s a good idea to do this research before you settle a debt for less than the full amount.

When to Consult a Tax Professional

We’re not tax professionals, and we can’t advise you on your specific situation. Even if you’ve done your own taxes in the past, once you’re considering debt settlement, your tax situation might already be complex enough to warrant a consultation with a tax pro. Look specifically for people experienced in debt forgiveness situations.