Income Tax Consequences of Debt Settlement

What are the tax consequences of credit card debt settlement? What is the tax impact to you when you negotiate a debt? Will I get a Form 1099 after settling a debt? Are there any tax reporting rules I should be aware of with respect to debt settlement? Yes, there are. Before you sign up with a debt settlement program, you should know the tax consequences of your actions. You should consider getting an opinion from your CPA before you start. If you do not have one, or your CPA is not familiar with the tax consequences of debt negotiation, please call me and I will give you the name of someone who does. Do not rely on anyone’s statements regarding tax consequences of settling debt (including this blog), other than a CPA.

That disclaimer made, here is the basic rule:

The amount you save in a debt settlement is not taxable if you have a negative net worth at the time of the settlement. If you have a positive net worth at the time of the settlement, it is taxable. You will receive a 1099-C (”C” stands for “cancellation of debt”) for all debts settled. In my experience, most of the clients we have settled credit card and other debts for had a negative net worth. But there were a few that had a positive net worth. So total up your debts. Then total the net value of your assets (so for your home, you take the fair market value and then subtract the mortgage and cost of sale if you were to sell it.) If your debt exceeds your assets, you are insolvent. If you have any doubt, call me, or get an opinion from your CPA.

This is called the “insolvency” exception to the general rule that cancellation of debt is taxable. You are insolvent to the extent that your liabilities are more than the fair market value of your assets immediately prior to the debt settlement. So you will need do a personal balance sheet of your assets and your liabilities. There are 2 forms that your CPA will file with your tax return. The first is form 982 and the second is your personal balance sheet.

There are more complex issues with respect to income tax ramifications of negotiating a debt. For example, IRAs and 401k holdings may not count toward your asset total for these purposes (this is very good news!). In other cases, some of your settlements may not be taxable (up to the point you become solvent), and then the rest will be. If you would like to discuss your situation with me, please call me at 303-520-3414. In many cases, our clients have been pleasantly surprised to find there is no tax liability.

Are attorney fees on debt settlement tax deductible against this income?  Yes.

Stephen Craig is a debt settlement attorney in Denver who works exclusively for individuals and small businesses in debt.

Tags: debts, settlement, tax consequences, tax reporting