If you negotiate a settlement agreement on a collection, charge-off, or credit card debt, will you be required to pay the IRS as if it were income? Maybe and maybe not.
The general rule is that if you owed $4,000 and agreed to settle for $1,000, then that $3,000 you were forgiven is considered as “income” and therefore taxable. But wait — there are exceptions to that rule!
Are You Broke or Partially Broke?
If you are considered insolvent, then you do not have to pay income tax on the settlement.
If you are considered partially insolvent, then you do not have to pay income tax on the entire settlement, only on part of it.
Insolvency is when your debt is greater than your assets. This applies to a lot of good people who don’t have much money or equity in real estate, automobiles, etc. If you’ve got $1,000 in assets and were forgiven $3,000 in debt, then you aren’t required to pay tax on it.
If you’ve got $4,000 in assets and were forgiven $3,000 in debt, then you only have to pay tax on $1,000. (4 – 3 = 1)
I am not a CPA, so I’m required to say this is my interpretation of the law, and that you should check with your tax accountant.
Was Your Settlement Less Than $600?
You do not have to claim income if your settlement-benefit was less than $600. Such as if you owed $1,000 and settled for $500, then your settlement benefit is only $500 and you aren’t required to tell the IRS.
Was Your Cancelled Debt a Gift?
If your debt was to a family or a friend, and then that person ended up saying, “You don’t have to pay me back after all,” then the forgiveness is considered to be a gift. In that case, you don’t have to claim it to the IRS. (How would they even know about it anyway, right? Nevertheless, it’s a rule.)
Did You Declare Bankruptcy?
Debt discharged in a BK is not income to be taxed.
Did the Creditor Fill Out Form 1099-C?
If the collector reported Form 1099-C to the IRS, then you can’t ignore it. Ask a tax professional whether or not you are considered “insolvent” or partially so. That way, you might be able to save on taxes.
If You Have to Pay Taxes on the Settlement, Will You Come Out Behind? Or Ahead?
Great question! Just because you are required to pay taxes on the amount forgiven, you could still come out financially ahead. It depends on how much money the settlement saved you and what your personal income and tax situation is. This is very individual, so you will need to speak with a tax professional to determine if it’s a yes or no for you personally.
What If You Overpaid Taxes Because You Didn’t Know About the Insolvency Rule or Made a Mistake?
Don’t despair! You can file an amended tax return and collect any refund that you are legally owed due to over-paying.
Best wishes and God’s blessings on your financial future. There is always hope for better days ahead. ~ Carolyn Warren