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Do You Owe Taxes on Settled Debt?

Sarah Edwards | February 24, 2023

If you settled a debt recently, you may be taxed for the difference.

Summary: If you have settled a debt recently, you probably owe taxes on the settlement unless the debt was cancelled as a gift or inheritance, met certain student loan cancellations, occurred as a result of bankrupcty, or you were insolvent. If you want to settle, make an offer with SoloSettle.

You've managed to eliminate your debt through settlement, and you're happily moving on with your life, no longer worried about meeting monthly minimum payments or missing them altogether.

One January afternoon, you open your mailbox to discover a notification from your old lender. What's in the notification? A 1099-C, especially for you. Cue the irritation!

Your 1099-C indicates that you have discharged debt through a settlement agreement during the past year. According to the notice, an amount of $6,000 was forgiven by your credit card lender. This notice matches what you recall, but you're unsure what the notice means. Do you pay taxes on debt? What should you do?

Do you pay taxes on debt?

The IRS has certain rules regarding the cancellation of debt. In some cases, you will owe taxes, but in others, you won't. For credit card debt that you've managed to settle through an agreement, any debt that was forgiven should be included as income. Specific language that the IRS uses indicates that:

“If you receive a Form 1099-C, that means an applicable entity has reported an identifiable event to the IRS regarding a debt you owe. Unless you meet one of the exceptions or exclusions, this canceled debt is ordinary income and must be reported on the appropriate form.” (IRS, 2021 Publication 4681)

Generally, you will need to include the debt that was forgiven as ordinary income on your tax return unless you meet certain criteria. This rule means it will be taxable.

What are the exemptions allowed for excluding my debt as ordinary income?

Most canceled debt will be counted as ordinary income unless it meets certain criteria. If the debt is canceled under the following circumstances, you may not need to include it as ordinary income:

  • Debt was canceled as a gift or inheritance.
  • Certain student loan cancellations.
  • Canceled debt occurred as a result of bankruptcy.
  • You were insolvent before the cancellation of the debt.

If your debt was canceled in any of the above situations, then you may not need to include it as ordinary income. There are a few other exceptions, but they are a bit more rare and won't apply to the majority of individuals.

You can consult the IRS Publication 4681 guidelines if you feel you might qualify for special circumstances, such as if your debt pertained to farming or a business.

What student loan cancellations can be excluded from ordinary income?

The IRS advises that if you are responsible for the student loan, and it is canceled or repaid by someone else, then you must include that amount as ordinary income. However, if you meet certain exceptions, you may not have to do so.

For example, teachers who have their loans forgiven due to their employment in specific facilities, such as designated inner-city schools, may not need to include their canceled debt as ordinary income.

There is also a special rule introduced for 2021 through 2025. This rule allows individuals with canceled student loans obtained from private lenders or for postsecondary educational expenses to be excluded from ordinary income.

This rule generally applies to all student loan debt for undergraduate or graduate-level expenses that is canceled during these years.

Do I owe taxes on debt canceled from bankruptcy?

Individuals who have filed and had their debt canceled through bankruptcy will not need to include the amount canceled as ordinary income for the year. This rule includes Chapter 7, Chapter 11, and Chapter 13 bankruptcies. To qualify, the debt canceled must have been approved by the court or have been part of a plan approved by the court.

What is insolvency? Do you pay taxes on debt if you are insolvent?

Insolvency, as defined by the IRS, means that:

“You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own.” (IRS, 2021 Publication 4681)

The IRS provides an insolvency worksheet to help you determine whether you were insolvent prior to the cancellation of your debt. The insolvency exclusion is one of the most common ways to prevent canceled debt from being included as ordinary income on the tax return.

What should I do if I don't meet any of these exemptions?

So do you pay taxes on debt? If you don't meet any of the common exemptions, you'll most likely need to include your canceled debt as ordinary income on your tax return. Before doing so, double-check IRS 2021 Publication 4681 to make sure you don't qualify for any of the less-common exemptions.

If you file form 1040 or 1040 SR, the amount of your canceled debt will be included as other income on line 8. It will also be included as a supporting amount for Schedule 1. This setup means that it will be included as part of the income you earned during the prior year and will be taxable.

If you typically receive a refund after you file your taxes, your refund may be less than you expect, or you may find out that you owe taxes, depending on the amount that is canceled and your overall financial situation.

Should you find that you do owe taxes, hopefully, it doesn't cause too much of an issue, and you will be able to pay them on time. The IRS offers several options to pay taxes over an extended period of time if you're unable to pay what you owe by the deadline.

To learn more about debt settlement and taxes, check out this video:

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