Debt settlement victory? The IRS might want a piece. Here’s how to avoid surprises.
Congratulations! You settled your credit card debt for a fraction of the original amount. That’s a major win in your debt journey. But before you celebrate, there’s a potential obstacle—the IRS may ask for a share of your debt relief.
Whenever you have a debt of $600 or more, the IRS will ask you to file a 1099-C Cancellation of Debt Form. Believe it or not, the IRS considers forgiven debt as income, meaning you may face taxes on the amount not paid. Don’t panic though, there’s an option called “insolvency” that may help save you from this tax bite.
How does insolvency work?
Simply put, if you have more debts than assets at the time of debt settlement, you may be considered “insolvent.” This means you’re financially underwater and the IRS recognizes your struggle. In this case, you may be able to exempt the forgiven debt from your taxable income.
How to claim the insolvency exemption:
The calculation for insolvency is simple math: Subtract your total liabilities (debts) from your total assets (savings, investments, etc.). If the result is negative, it may be considered insolvent.
Let’s look at an example provided by the good folks at CreditCards.com:
Let’s say that last year you had assets totaling up to $50,000 but owed $53,000 due to debt. In that case, you were insolvent by $3,000.
Now let’s say you had $5,000 in debt forgiven through debt negotiation or a debt relief program. The $5,000 canceled debt income would be reduced by the $3,000 insolvency. Only the remaining $2,000 in forgiven debt would be reported on the tax return as income. If the person was insolvent by $5,000 or more, then all the canceled income would be exempt.
Seek Out Resources
Make sure to consult IRS Publication 4681 and Form 982: These resources can help guide you through claiming the exemption. And don’t be afraid to seek professional help, because while you can in theory navigate the paperwork yourself, a tax advisor may be able to maximize your exemptions. They can ensure you claim the exemption correctly and avoid any potential tax issues.
Key points to remember:
- Receiving a 1099-C doesn’t automatically mean you owe taxes.
- Insolvency is a legal exemption that can shield you from taxes on forgiven debt.
- Claiming the exemption requires proper documentation and potentially professional guidance.
While debt settlement can be a great way to regain financial control, understanding potential tax implications is crucial. Don’t let the IRS rain on your parade! Take charge, utilize the available resources, and celebrate your financial progress without any unexpected tax surprises.
