Do I Have to Pay Taxes on Debt Settlements?
If you settled a debt for less than you owed, you may owe taxes on it
By Judy Malmon, J.D. | Reviewed by Canaan Suitt, J.D. | Last updated on August 14, 2024 Featuring practical insights from contributing attorney Kevan P. McLaughlinUse these links to jump to different sections:
- The Difference Between What You Owed and What You Paid in a Debt Settlement Is Considered Income
- Notifying the IRS of a Debt Settlement with IRS Form 1099-C
- Exceptions to Paying Taxes on Debt Settlements
- Find Experienced Legal Help
For most taxpayers, figuring out our income tax is hard enough. What about taxes based on money you never had? The concept is difficult to comprehend, never mind calculating the amount due each tax year. But don’t panic—this is actually a pretty common situation, albeit not intuitive.
The Difference Between What You Owed and What You Paid in a Debt Settlement Is Considered Income
If you have a debt that you owe but enter into a settlement for less than the total amount of the debt, the difference between what you owed and what you paid is considered income to you.
For example, if you had a loan for $100,000 and the lender agreed to settle the amount of debt for $75,000, the IRS looks at the $25,000 you no longer have to pay as income. As such, this amount is subject to income tax and needs to be declared in your tax return for the year you received the write-off.
Notifying the IRS of a Debt Settlement with IRS Form 1099-C
“The cash value of debt is hard to conceptualize, and this can lead to big problems,” says San Diego tax attorney Kevan McLaughlin. “The general rule is when you got the line of credit—loan, mortgage, whatever—there’s no tax because it carries with it the reciprocal obligation to repay it. If you don’t repay it, the government looks at that as money in your pocket, and you have to pay tax on that. So, you’re paying tax on something and don’t have the cash. It’s taxed as ordinary income, up to the amount of the debt that was forgiven.”
If you settled a debt with a lender or credit card company, they are required to notify the IRS of the debt settlement and send you an IRS Form 1099-C, Cancellation of Debt tax form. It is not a good idea to pretend you didn’t get it.
There may, however, be an exception to having to pay the tax.
Exceptions to Paying Taxes on Debt Settlements
“If you were insolvent the moment before the debt was forgiven, it’s not taxable income,” McLaughlin adds. “Insolvency is defined as your liabilities exceed your assets.”
However, you would still need to account for the write-off in other ways on your balance sheet. “There’s a sequence where you have to reduce your tax attributes of other assets, although it’s not income to you. For example, if you have a $100,000 debt forgiven and are solvent, that’s $100,000 of ordinary income. If you have $100,000 debt forgiven and you are insolvent, it’s not income, but you have to reduce other assets by $100,000.”
A debt reduction or cancellation may also be excluded from taxable income if your debt comes under one of the following:
- Bankruptcy
- Qualified farm indebtedness
- Qualified real estate business debt
- Qualified home loan that was discharged before January 1
Each of the above exclusions would require a reduction in assets, as described for insolvency.
There may also be an exception to the debt cancellation that keeps it from being counted as income for tax purposes, such as:
- Qualified student loan forgiveness programs (for example, working in a listed profession for certain employers for a designated amount of time or providing health services in designated locations)
- Cancelled debt that would be tax deductible if paid
- Reduction in the purchase price provided by the seller
- Debt cancellation that is a gift, bequest, devise or inheritance
Find Experienced Legal Help
If you’re unsure how to account for a forgiven debt, talk to a tax preparer or an experienced tax advisor. The best time to consult with a tax attorney is before you enter into a cancellation agreement to see if you’ll qualify for an exclusion or exception and avoid unnecessary payments. For more information on this area of law, see our tax overview.
What do I do next?
Enter your location below to get connected with a qualified attorney today.Additional Personal Taxes articles
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- Getting Legal Help to Defer Capital Gains Taxes on Real Estate
- When You Hit the Jackpot, So Does the IRS
- Which Divorced Parent Gets to Claim the Kids in Taxes?
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