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If you’re overwhelmed by aggressive collection calls, you may consider settling your debt for less than you owe. This is a good option for people in over their heads, but it doesn’t come without its difficulties. Read on to find out what debt settlement means for your taxes.
What is debt settlement?
Debt settlement is an agreement between the creditor and the borrower. Both parties agree on a reduced amount to pay off the debt in full. The borrower gets the advantage of paying a smaller amount than he owes, and the creditor gets paid at least something instead of having to write off the entire balance.
Of course, debt settlement doesn’t come without its costs to the borrower. Debt settlement will appear on your credit report as such and hurt your credit score. Also, you may have to pay taxes on the difference between what you paid and what you owed. Yes, the amount of debt you didn’t pay is generally reported to the IRS as income.
The tax implications of settling your debt
While settling your debt may be a huge relief, you need to be prepared to pay taxes on the amount settled. Depending on the type of debt, your creditor may send you a 1099-C cancellation of debt tax notice. This information will be reported to the IRS, and you'll need to report it as "other income" on your tax return. One exception is for student loan debt forgiveness: The American Rescue Plan that President Biden signed into law in March 2021 exempts student loans forgiven through December 2025 from being considered gross income.
While you might be left on the hook paying taxes, you have a few options for tax relief if that's the case.
Even if you don’t receive a 1099-C, you may still be legally required to report canceled debt as income. As with anything else, there are exceptions; you can find the exceptions and more information on IRS Publication 4681.
How much do I have to pay?
This income is taxed at your normal tax rate, which range from 10% to 37% for 2021, based on your taxable income. The United States has a progressive tax rate, meaning that the tax percentage increases as the taxable base increases.
What if I choose not to report it?
Legally, you must report all taxable income received — and this includes your debt settlement amount. If a 1099-C is issued to you, the IRS is also receiving a notice of income, and you can be penalized for not reporting. You’ll have to pay not only the tax you owe, but also fines.
If you don’t receive a 1099-C, the IRS won’t receive this information either. However, if you’re chosen for an audit for any reason, this will likely be discovered. Stay on the right side of the law and report all income. It isn’t worth it to break the law and underreport.