How Consumer Debt Can Lead To Tax Liabilities & Problems

Whenever an individual chooses a debt program which allows them to pay less than the total amount owed, there are always potential tax consequences. The IRS in most cases consider consumer debt that is cancelled or forgiven as income. Getting out of debt is a necessary goal to become financially stable – but in many cases with debt settlement, you could find yourself with new tax liabilities or tax debt that results in larger financial difficulties than you experienced before.

If you’re paying back debts in full, there are no tax consequences to worry about. Many debt management plans, Chapter 13 Bankruptcy, and debt consolidation all require that the total amount owed is eventually repaid, and therefore your debt will not adversely affect your taxes. For all other debt repayment options that involve paying only a portion of the balance owed, the situation becomes complex and can often result in a negative affect on your taxes.

Settling Debt for a Lower Amount Than You Owe

If you or a debt management company negotiate a lower payment than the total amount owed to officially close out the account and fulfill your responsibilities, than the amount the creditor forgives is considered income at tax time. If you owe $12,000 but the creditor agrees to accept $3,000 instead, you’ve just added an additional $8,000 to your taxable income.

Whenever a company forgives debt for a consumer (like Credit Card Debt), they must submit a form to the IRS (1099-C) and to the consumer. The consumer uses the form to report the income on their tax return during the year the debt was forgiven. Most of the time, the forgiven debt is reported on a 1099-C to both the IRS and the consumer, and then the consumer includes the amount forgiven on line 21 of form 1040; or 1040-A when filing their tax return.

In some cases, there are exceptions. For example, the Mortgage Forgiveness Debt Relief Act of 2007 states that you can have up to $2 million in mortgage debt forgiven as long as the house associated with you discharging debt was your primary residence. This includes debt through mortgage restructuring or in connection with a foreclosure. This act covers consumers through 2012. Realize, this act though does not apply to credit card debt, car loans, or mortgages associated with second homes.

Chapter 7 Bankruptcy

In a Chapter 13 Bankruptcy, the consumers debts are simply reorganized into more affordable payments. The consumer is still responsible for paying their debts so usually no. In a Chapter 7 Bankruptcy, part or all of a consumer’s debt is forgiven, which means there is taxable income associated with the bankruptcy according to the IRS.

In many cases, an individual filing Chapter 7 is insolvent, meaning their liabilities exceed the fair market value of their assets. If this is true, then income from canceled debt is not counted as income on the tax return (up to the amount of their insolvency). If the consumer does not have liabilities that exceed their assets, then the income realized from filing bankruptcy is used to reduce certain tax attributes. For example, if you had $30,000 in credit card debt, and $20,000 in assets, you are insolvent by $10,000. If your credit card company settles with you for $15,000, you essentially would report $5000 in taxable income on your tax return.

You can fill out the Insolvency Worksheet (use the one in IRS Publication 4681) provided by the IRS to determine whether or not you are considered insolvent, and by how much. The amount of insolvency is then reported on IRS form 982, as well as the amount of debt involved in the bankruptcy.

Other Exceptions

Realize there are other exemptions where forgiven debt is not considered taxable. This includes certain student loans that are forgiven when you agree to work for the government or government related organization for a certain period of time, debt cancelled with a Chapter 11 bankruptcy (in most cases), and debt that was forgiven because the debt was accumulated form your identity being stolen. When in doubt, speak with a tax professional if you have questions in reporting forgiven or cancelled debt.

This is a guest post was provided by TaxDebtHelp.com, a website that provides informational articles and tax relief services to taxpayers needing IRS debt help.

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1 Comment

  1. Eric says:

    Great points! I did not consider the tax liabilities of all those debt settlement companies. Make that reason #435 why we shouldn’t believe those radio ads claiming to take my $10k of debt and turn it into $5k overnight.

    Keep up the good work,
    Eric

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