Viewer Question: If I Settle a Debt, Do I Have to Pay Taxes?

Nothing like a kick while you’re down! Here’s a question I recently received from a viewer:

When my husband passed away two years ago, I was left with a lot of debt and no life insurance to pay any of it. I called all the credit card companies to try to work something out. I ended up making a deal with two companies to pay a lump sum and they would forgive the rest. However, I didn’t know they would send me a 1099 for what they forgave. Do I have to report this as income? It wasn’t income and I was not told about this when I made the deal.

-Karen

Here’s your answer, Karen!

In a word, yes. You do have to pay income taxes when you settle a debt. As far as Uncle Sam is concerned, when you borrow money and don’t pay it back the money you didn’t repay is considered income and taxed just like any other income you receive. So if you owe a credit card company $10,000 and settle the debt for $5,000, you’ve just generated $5,000 in taxable income, which you’ll normally see in the form of a 1099-C when tax paperwork starts rolling in. If you’re in the 25% tax bracket, an additional $5,000 of income means you just increased your income taxes by $1,250 (25% of $5,000.)

This is something that is often not revealed by creditors or even some companies in the debt settlement business. (That’s one reason I’m not so fond of debt settlement companies. Here’s a story I did on them: Should You Consider Debt Settlement?)

By the way, these rules don’t just apply to credit card debt: they also apply to mortgage debt. Normally if you lose your home to foreclosure and the amount it’s sold for is less than the mortgage, that amount (known as a deficiency) can also be reported as taxable income to you: salt in an already terrible financial wound. But the key word in that last sentence, however, was “normally.” The Mortgage Forgiveness Debt Relief Act of 2007 provides tax relief for those who lost their home to foreclosure in 2007, 2008 and 2009, The Emergency Economic Stabilization Act of 2008 extended the exclusion from gross income for the discharge of qualified principal residence indebtedness by an additional 3 years. So the exclusion now applies to foreclosures from 2006 to 2012.

There are exceptions (e.g., has to be your primary residence, can’t be more than two million dollars, doesn’t apply to loans used for other purposes that were secured by your house) but in general if you lost your home to foreclosure, you won’t have to include forgiven mortgage debt in your taxable income. That’s a very lucky break. Read more about exactly how the rules apply at this page of the IRS website.

Of course, foreclosure relief doesn’t help those like Karen with forgiven credit card debt, but here’s something that might. If you can prove that you were insolvent, you can file IRS Form 982 and skip adding forgiven debt to your taxable income. “Insolvent” means that your debts are bigger than your assets: in other words, you owed more than you owned.

For more details on all this, check out this simply worded article from Nolo that discusses debt settlement in more detail.

This post comes at a good time, because just yesterday I wrote an article suggesting most people are better off using software than hiring a tax professional: Tax Pros: Getting What You Pay For. Karen’s situation is a great example of an exception. Because she can really use some expert tax advice in this situation. She should read more about this subject, take a look at IRS form 982, then talk to a tax pro and see if maybe she can avoid an unexpected and unpleasant addition to her tax bill.