How Debt Settlement Affects Tax Filing

Going through the process of debt settlement can provide you with the benefit of eliminating your debt. You will often be able to negotiate a much lower payment than what you owed. While this presents you with a way to save money, there are some tax considerations that you will want to be aware of. Here are the basics of how debt settlement affects tax filing. 

Debt Settlement

When you go through the debt settlement process, you will be negotiating with one of your creditors. You will owe them a certain amount of money, but you will settle for a lesser sum. For example, you have a $5000 credit card balance that you cannot afford to make the payments on. You have missed several payments in a row for various reasons. Then they start to call you and send collection notices to you. Eventually, you come to an agreement with the creditor that you will pay $3000 of the debt, and the creditor will close the account for you. 

During the process of the debt settlement, you come out ahead by $2000. While this may seem like free money and a huge bonus for you, it comes with some strings attached. For one thing, your credit will be adversely affected. In addition to that, you are responsible for the tax burden on that $2000 because it is, in effect, money earned. Many people are unsure of how to handle this on their taxes. 

Debt Settlement Taxes

After the debt is settled, you will have to account for this cancellation of debt on your personal income taxes. When the arrangement is made, you will pay the creditor the amount of money that you owe. In the above example, you would send them $3000. You should then take note in your personal records of how much money you saved from the original debt. Mark down that you gained $2000 in this transaction. If you settle only one debt in the year, you may find it easy to remember. However, if you settle several debts at once with a lump sum, you will want to keep detailed records for your taxes.

At the beginning of the next year, the company that you settled with will provide you with a tax document that says they canceled a certain amount of debt for you. This type of document is referred to as a 1099-C. This is standard when a cancellation of debt takes place. 

Filing the Taxes

When you receive this type of income statement from a former creditor, you will have to report it as income on your taxes. If this happens to you, it is probably in your best interest to have a tax professional handle the filing for you. This will allow you to handle the filing correctly and make sure that you do not list it in the wrong place on your tax return. 

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