How Does Debt Settlement Affect Your Taxes?
Debt settlement involves paying off a debt in one lump sum for less than the total amount owed. In most cases, before a creditor will agree to a debt settlement, you must be seriously delinquent on your payments. Consider carefully before entering a debt settlement agreement, and discuss your specific financial situation and tax consequences with an accountant, financial advisor or tax preparer.
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Tax Treatment of Cancelled Debt
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When you settle a debt, the unpaid portion is considered "forgiven" or "cancelled" debt. If the amount of cancelled debt is $600 or more, the creditor will send a Form 1099-C, "Cancellation of Debt," to both you and the Internal Revenue Service. Whether you receive a 1099-C or not, the cancelled debt may be included in your income unless you qualify for an exception or exclusion.
Exceptions
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Occasionally a creditor will forgive debt as a gift to you, in which case you do not have to include the debt in your income. Student loan debt that is waived upon completion of a certain type and term of employment also is not included in income, such as a teacher whose student loan debt is forgiven after she works for two years in an inner-city school system. Additionally, debt that would have been deductible had you paid it, such as mortgage interest, is not considered a part of your income when the debt is cancelled.
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Exclusion of Qualified Principal Residence Indebtedness
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If the cancelled debt qualifies as principal residence indebtedness, it is not included in your income. Qualified principal residence debt is a mortgage used to purchase, build or significantly improve your primary home. If you refinance for a higher amount of debt, the qualified indebtedness is limited to the principal balance immediately before you refinanced. In that case, you can only exclude the amount of cancelled debt above the excess amount you refinanced. If you refinance for $100,000 more than the current principal balance, for example, and later have forgiven debt on your home of $110,000, you can only exclude $10,000 from your income.
Exclusion Due to Insolvency
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You can exclude cancelled debt from your income if you were insolvent immediately before the debt was cancelled. To determine whether you were insolvent, add all of your debts before the cancellation together. Next add the value of all of your assets before the cancellation. Assets include the fair market value of your property, such as your home, cars, clothing, furniture, jewelry, and so on. Assets also include your bank account balances, investments and retirement accounts such as an IRA or 401(k). If your liabilities exceed your assets, you are insolvent and can exclude forgiven debt from your income, up to the dollar amount of the insolvency. You can exclude cancelled debt on your main home through either the qualified personal residence debt exclusion or the insolvency exclusion, but not both.
Other Exclusions of Cancelled Debt from Income
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Debt discharged in a bankruptcy is not reported as income. The bankruptcy exclusion may cover debt that qualifies for other exclusions; however, any debt discharged in a bankruptcy must be claimed under the bankruptcy exclusion. Other exclusions include qualified farm indebtedness and qualified real property business indebtedness. If you exclude debt from your income, you must reduce your basis in related assets for future tax years.
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