Debt settlement occurs when a debtor successfully negotiates a payoff amount for less than the total balance owed on a debt. This lower negotiated amount is agreed to by the creditor or collection agency and must be fully documented in writing. The settlement is often paid off in one lump sum, although it can also be paid off over time.
Although creditors are under no legal obligation to accept debt settlement offers, negotiating and paying lower amounts to settle debts is far more common than many people realize. A successful debt settlement can result in savings of thousands of dollars while relieving chronic aggravation and stress by putting an end to a seemingly endless cycle of monthly payments.
However, following a debt settlement, you may owe additional taxes to the IRS. Learn more from the experts at United Settlement about how debt settlement affects taxes.
How Does Debt Settlement Affect Taxes?
The process of debt settlement focuses primarily on unsecured debt, such as high-interest rate credit card debt. Creditors become more likely to settle once a debtor has already demonstrated an inability to pay – as evidenced by delinquent accounts of four to five months or longer.
This can be the sweet spot for a debtor who wishes to pursue debt settlement since the creditor is well aware that the delinquent account(s) are inching closer to charge-off status – and that they may soon be worthless or worth only pennies on the dollar in a sale to a third-party collections agency.
Therefore, the creditor becomes more willing to accept less than the full balance owed, knowing that a smaller slice of the pie in the form of a negotiated debt settlement may be its best option.
Following a debt settlement, the creditor will report to the IRS the amount that the debtor did not pay (the forgiven debt) as lost income. The IRS recognizes any forgiven debt over the amount of $600 as taxable income, so any amount of savings that a debtor achieves in debt settlement over this amount will be reduced by a tax liability.
The financial institution that settles is responsible for sending a Form 1099-C to the debtor at the end of the tax year. Situations do arise when a debtor does not receive a 1099-C – either through outright omission by the financial institution or by the debtor overlooking the piece of mail when it was actually received. In either instance, it remains the responsibility of the debtor to report debt settlement savings in excess of $600 as taxable income.
Unfortunately, it can be the case that when a debtor has no knowledge of having received a 1099-C, the financial institution has reported the settlement to the IRS, exposing the debtor to further liability that may now also include IRS interest expense and penalties.
There is an exception to the rule of being required to pay taxes on settlement amounts that exceed $600, and it relates to insolvency. Insolvency occurs when the value of an individual’s debts exceeds the value of an individual’s assets. If, prior to debt settlement, it can be shown that the debtor was insolvent, then there will be no tax liability due on any settled amount less than or equal to the amount of the insolvency.
For example, if someone has $50,000 worth of total debt and only $40,000 worth of assets, there is a $10,000 insolvency. Any settled debt for up to $10,000, therefore, will not be subject to taxation. However, once the $10,000 threshold is met, any excess settlement amount above that becomes taxable. A $12,000 settlement savings, for example, would result in $2,000 of taxable income in this scenario.
Are Debt Settlement Fees Tax Deductible?
The question of whether debt settlement fees are tax deductible poses a little bit of a grey area. The good news is, if you engage the services of a debt settlement firm (not a lawyer) that successfully negotiates a debt settlement on your behalf and then charges a fee based on the amount of the settlement achieved, the fee paid to the debt settlement firm qualifies as a miscellaneous itemized deduction when filing income taxes. However, if you engage a lawyer for the purposes of debt settlement negotiation, any legal fees associated with the debt settlement process will not be tax deductible.
Only those legal expenses incurred when attempting to produce or collect taxable income, or related to tax collection and tax advice, are tax deductible. Legal fees associated with debt settlement are considered personal expenses, and therefore are not tax deductible.