How to Pay Taxes on a Debt Settlement
No matter how high or low the national unemployment rate is, some people will find it difficult to pay their debts. Relief may come in the form of a debt settlement, in which you pay off a portion of the debt in exchange for forgiveness of the rest. Many people are surprised to find that the forgiven debt is considered taxable income.
A creditor that forgives more than $600 in debt is required to report the amount forgiven on IRS Form 1099-C. Forgiven debt under the $600 threshold is still taxable income but the creditor isn't required to report it; instead, it's up to you report the income.
While it's always prudent to discuss potentially complicated tax situations with a qualified tax professional, this guide will walk you through the portion of your tax return that deals with a forgiven debt. At the very least, you will have a better understanding of your tax situation this year.
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Things You'll Need
- Form 1099-C
- Final account statement of forgiven debt
- IRS Publication 4681
- IRS Form 1040 tax return
- IRS Form 982
- Calculator
- Pencil
- Scratch paper
Instructions
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Determine If Cancelled Debt is Taxable
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1
Review the exceptions and exclusions listed in IRS Publication 4681 (see Resources) to determine if your debt is taxable.
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2
Enter all of your outstanding loans, credit card debts and other liabilities that you owed just prior to cancellation or settlement of a debt in the appropriate lines on part 1 of the insolvency worksheet in IRS Publication 4861.
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3
Total the amounts in Step 2 and enter the sum on line 17 of the insolvency worksheet.
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4
Record the fair market value of all assets you owned just prior to the cancellation or forgiveness of a debt on the applicable lines in part 2 of the insolvency worksheet. Include cash, account balances, property, vehicles, household goods, electronics, tools, jewelry and so on. Be sure also to include stocks and bonds, investments, retirement accounts, cash value of life insurance policies, ownership value of businesses and any other assets.
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5
Total the value of all assets in Step 4 and enter the sum on line 39 of the insolvency worksheet.
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6
Subtract the value of your assets (line 39) from the sum of all debts owed (line 17) and enter this amount on line 40 of the insolvency worksheet. If this amount is greater than zero, it indicates your amount of insolvency.
Calculate and File Your Taxes
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7
Subtract the amount of your insolvency, if any, from the amount listed in box 2 on the 1099-C from your creditor. This result is the amount of forgiven debt that is taxable income.
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8
Enter the taxable amount of the debt on line 21 of your Form 1040 income tax return.
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9
Complete Form 982 and file it with your 1040 tax return.
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1
Tips & Warnings
Tax laws frequently change. Review the latest versions of all applicable tax forms as well as any supplemental information that may be provided on the IRS website.
Tax issues at this level require the advice of a tax professional.
References
Resources
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