Before you enter into any debt settlement program, you should make sure you understand the potential tax consequences. The question of what effect debt settlement could have on your income taxes is one best left to a certified public accountant (CPA), so do not rely on the advice of non-CPA sources (including this website) regarding your specific situation. If you do not have a CPA, or your CPA is not familiar with debt settlement, contact us and we will refer you to a qualified CPA with the necessary expertise.
That disclaimer made, here is the rule of thumb:
Cancellation of debt may or may not be considered a “taxable event,” depending on a person’s financial situation at the time they settled their debts. If you had a positive net worth at the time of the settlement, any savings over $600 will be treated as taxable income. You’ll receive a 1099-C form (the “C” stands for “Cancellation of Debt”) for every debt on which you saved $600 or more, and those amounts will be considered taxable income. In contrast, if you had a negative net worth at the time of the settlement—in other words, if your liabilities exceeded your assets at that time—you will owe no taxes on the amount of debt that was cancelled.
For the most part, our debt settlement clients have had a negative net worth at the time of their settlements and so their debt savings was not taxable. We have also had clients who had a positive net worth when they settled their debts, so their situations were different. Doing some quick math will give you a general idea of where you stand. Add up all your liabilities. Add up the net value of all your assets, including home, car, belongings, bank accounts, etc. (For your home, take the fair market value and then subtract what you owe on the mortgage and any costs that would be associated with selling it). If your combined debt exceeds the combined value of your assets, you would be considered “insolvent”—that is, you would have a negative net worth and would face no additional tax liability.
There are other, more complex issues with respect to the income tax ramifications of negotiating a debt settlement. It may be the case that you were insolvent when you settled some debts but then became solvent at some point during your debt settlement program. In that event, the settlements you reached while insolvent won’t be taxable, whereas the settlements that occurred after you became solvent will be. Another issue has to do with determining the value of your combined assets. For instance, IRAs and 401(k) holdings may not count toward your asset total for these purposes (this is very good news!). As I said at the beginning, a CPA can advise you regarding how debt settlement could affect your tax position. If you need the name of a qualified CPA, or you would like to discuss your situation with us, feel free to call us at 303-520-3414. In many cases, our clients have been pleasantly surprised to learn that they’ll have no tax liability from settling their debts.
Steve Craig is an experienced bankruptcy and debt-settlement attorney based in Denver, Colorado.