Debt settlement may have tax consequences, but usually will not. A creditor can issue a 1099 form reporting how much of your debt was forgiven, but the IRS takes the position that these monies are not taxable income if the debtor was “insolvent” at the time of the settlement. “Insolvent” basically means that you had more debt than assets. If you are “solvent,” that is, if your assets exceed your debts, then debt settlement may not be the right answer for you because you could end up with a tax liability.

So that’s the punch line- generally it is not.  But here is more detail:

Claiming Settled Debt on Taxes

Generally, if your debt is canceled or forgiven, other than as a gift or bequest to you, you must include the cancelled amount in gross income for tax purposes.  If a financial institution forgives debt of $600 or more, you will receive a 1099-C, Cancellation of Debt.  The amount of debt cancelled is shown in box 2.  If the debt is a nonbusiness debt, report the canceled amount on line 21 of Form 1040.

There are exceptions, though, to this general rule.  These exceptions are detailed in IRS Publication 225.  We suggest you review these exceptions with your tax advisor.  In order to claim an exclusion on your income tax return for a canceled debt, you will need to complete and attach Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.

Consult Your Tax Lawyer

One specific exemption deals with insolvency.  In determining if this exemption applies, calculations involving the fair market value of your assets and your total liabilities must be made.  You are insolvent to the extent your liabilities are more than the fair market value of your assets immediately before cancellation of the debt.  You can exclude canceled debt from gross income up to the amount by which you are insolvent.

There is another, less known exception for deductible debt.  The rule is this:  You do not realize income from a canceled debt to the extent the payment of the debt would have been a deductible expense.  Here is an example the IRS uses:  You get accounting services for your business on credit.  Later, you have trouble paying your business debts, but you are not bankrupt or insolvent.  How you treat the cancelled debt depends on your method of accounting.  Cash method– You do not include the canceled debt in income because payment of the debt would have been deductible as a business expense.  Accrual method– You include the canceled debt in income because the expense was deductible when you incurred the debt.

At Trident Debt solutions, for every debt settlement client we have, we discuss tax implications prior to enrolling anyone into a debt relief plan.