Debt Settlement – An Unsettling Surprise
For those of you who think that settling your debt is the end of the line, think again, the IRS wants a cut.
Typically, a few months after a consumer settles their debt with a creditor or debt collector, they receive a Cancelation of Debt notice from the IRS, also known as form 1099-C. Here is a sample copy.
You see, the IRS considers forgiven debt as a form of income, and this income MUST be reported in your tax return.
Here’s an example of how this works:
You call up a debt collector to settle a $5,000 collection account. Through your shrewd negotiating skills, you’re able to settle the account for $1,000.
Great Job!! You pay the $1,000, the balance is reported as $0, the account is closed and the collection agency then files a Form 1099-C to the IRS, reporting the $4,000 you didn’t pay as your income.
And this could lead to quite a large tax burden.
The issue is that most people don’t realize that they have to pay taxes on their forgiven debt. The law does not require debt collectors to divulge this information to consumers and why would they. It’s not exactly an attractive proposition and it’s not their job to help you do your taxes.
The Good News
The good news is that you may be able to reduce or even eliminate this tax burden by filing a simple form – IRS Form 982 also known as the Reduction of Tax Attributes Due to Discharge of Indebtedness.
Well, that’s a mouthful. But do yourself a favor, if you receive a 1099-C Cancelation of Debt form, take it to a knowledgeable accountant. There are several exclusions that could offset the “debt income”. One example of an exclusion is if your Liabilities are greater than your assets, meaning that your net worth is negative, you may not be liable for the cancelation of debt income.
There’s one more thing that I need to mention, technically, mortgage lenders file form 1099-C from consumers that have had short sales and foreclosures. Obviously, the amounts that they could possibly report as debt income could be astronomical.
There is an exclusion for these cases as well, it is called the Mortgage Forgiveness Debt Relief Act, and it covers up to $2 million in forgiven mortgage debt, as long as it is filed by April 2014. This will be the last year that the act is valid, so it is important that you get all of your ducks in a row before you file your taxes.
The Bottom Line
Be aware of the fact that you have a tax liability on any forgiven debt. And be sure to contact an expert accountant who can help you navigate the tax laws to save you money.
Also, be aware that CreditFirm.net is always here to help you improve your credit with an expert team of credit consultants and attorneys at your service.