The Debt Settlement Tax Can Bite If Not Careful
If you’re currently in debt and you may be thinking about negotiating with your creditors to settle your debts for less than you owe. What you may not know about debt settlement, though, is that it can have a significant impact on your taxes.
If you negotiated a settlement with your creditors, you’re basically “earning” money from your debt. Here’s how it works: If you took out a loan for $10,000 and couldn’t pay it back, but negotiated with your creditors for them to accept $6,000 as full payment of your loan, you’ve pocketed $4,000 (the difference between how much you borrowed and how much you paid back). The IRS takes a close look at these kinds of loan repayments.
It’s possible that at some point in the past, the U.S. tax laws allowed for this to happen with no tax implications. Unfortunately for you, the IRS is smart about such things now, and has closed any loophole that may have existed in the tax law.
As in our example above, if you settle credit card debt or any other type of debt for less than you owe, you will probably be held liable for whatever “profit” you realize after settling your debt. Remember this when it’s time to file your taxes after settling your debts.
Even though this debt settlement tax may sound like a bad thing, you’re still better off having settled your debt, even after taxes. In our example, you’ve realized a $4,000 “gain”, but at most you’ll have to pay about 30% (depending on your tax bracket). Even after you’ve paid the tax, though, you still only paid $7,200 in repayment of a $10,000 debt. That’s a 28% discount, and is still a huge bargain.
Because the debt settlement tax comes as a surprise to many people, they don’t do anything about it until the IRS comes to audit them. Don’t let this hidden tax take you by surprise.
If you need any more details on how to deal with this tax, please check with your CPA or another tax expert.
About the Author: Sean Payne is a personal finance expert who has learned through trial and error (and a lot of advice) how to get out of debt. You can learn more about the debt settlement tax at Sean’s website, which can be found at http://www.debtpayofftips.com
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Hey Sean,
Great post. One thing I would add though, would be the insolvency rule. I wrote a post about it on my site last month. The just of it is that if you are insolvent at the time the debt is forgiven then you can typically have any tax liability from the forgiven debt waived and owe nothing to the IRS. Most people that seek debt settlement are so far upside down financially that they can qualify under the insolvency rule.
Excellent article, I think it’s important that we are all made aware of the ins and outs of debt settlement; many people tend to have a preconceived notion of it which isn’t helping anybody.
Most people in a financial hardship who must settle their debts can easily qualify to be exempt from paying ANY taxes on forgiven debt.
Here is a complete explanation of avoiding taxes due to the forgiveness or discharge of debt: http://www.debtgotoguy.com/debt-settlement/debt-settlement-tax-avoidance/
You make a great point:
Paying taxes on debts that are forgiven is far better than paying the full balance plus interest, especially if you are struggling to just pay the minimum payments.
Earlier today a client of mine asked about this, and here’s what I emailed her:
Consider this…
If you settled all of your $100k of debt for $50k and (worst case scenario) had to pay taxes on all of the debt forgiven ($50k), then you may pay an additional $15k in taxes, (more or less depending on your tax bracket, deductions, credit, etc…) BUT you would still save $35k PLUS all the additional interest you would have paid if you stayed in debt. This additional interest compounds and can be substantial. Even at a low average interest rate of 7%, it would take 26 years to pay off $100k with minimum payments and cost you over $30k in interest. The average interest rate in America is 18.9%, which would take 51 years to pay off with minimum payments and cost over $169k in additional interest (total cost over $269k). These numbers are all considering you never charge another dime.
So finding a way to get out of debt fast and stop paying interest allows you to put the money you’re paying in interest now towards savings and investments that can earn interest for you. Over time, this can quickly add up to a million dollar difference.