Getting your loan approved seems like the best thing that could ever happen and people usually assume that the loan will fix all their financial problems. However, the trouble begins when they have to arrange funds to make their monthly repayments, that’s where people usually get stuck. The reason is that they aren’t just returning the money they took in fact, they have to deal with the interest rates too. In simpler words, getting a loan is easier but returning it is full of hassle.
Now for people who aren’t able to pay off their loans in full, there are multiple debt relief options out there. Debt settlement is one of the most common ones because it just simply reduces your debt. In a settlement negotiation, you pay your creditor a lump sum of the total amount you owe and the creditor forgives the rest of your loan. Sounds simple? Well, it isn’t because just any other debt relief option, settling your loan comes with a cost. First of all, it’ll negatively impact your credit and the one downside people often don’t know about is that the forgiven amount is sometimes considered taxable by the IRS.
Today, we are going to discuss the tax implications of a debt settlement in detail so that when you negotiate a settlement, you know what you are dealing with.
Does The IRS Tax Forgiven Debt?
Debt settlement taxes are real and the IRS does tax the amount of loan your creditor forgives. The rationale here is simple: when you are borrowing money from a lender, you are expected to pay it back in full. If it’s not possible and you want to settle your loan then the IRS views your forgiven amount as taxable because as per them the forgiven debt is the money you received but no longer have to pay it back. This is what they view as their income.
For example, if you owed an amount of $15000 on a credit card and then you got it settled for $9000, the rest of the $6000 forgiven will be considered as cancellation of debt income (COD income). This amount will be subjected to income tax. Any creditor that forgives more than $600 is obliged to provide a 1099-C form to both the borrower and the IRS to report the cancellation of the loan amount. The exclusions provided by the IRS are only for those declaring bankruptcy or insolvency. Other than that, you have to report your forgiven figure on your tax return. In case you ignore or neglect the tax, it’ll come with severe consequences like higher interests, penalties or even an IRS audit.
Understanding the 1099-C Tax Form
Now that you know the answer to “is debt settlement taxable?”It’s time to learn about the 1099-C Tax form. The 1099-C form is titled as “Cancellation of Debt” and it’s compulsory for your lender to give this form to both you and the IRS to inform them that he has forgiven more than $600 of debt. The amount then is listed into your taxable income of the year. Key elements of the form include;
Identification Information: The 1099-C form includes all the basic information of the creditor who’s forgiven the debt along with the debtors information. It also includes the taxpayer identification numbers (TINs), names and addresses. There’s another section in the form where all the other information like the date the debt was cancelled and the account number is mentioned.
The Cancelled Amount: In the second box, all the information about the amount cancelled during the relevant tax year is included. Cancelled debt is considered taxable unless there’s an exemption by the IRS.
Reason For Cancellation: In box six, you’ll see a code that indicates the reason behind the settlement and why the borrower wasn’t able to pay the loan in full.
Exemptions And Exclusions: Some forgiven debts come with tax exemptions by the IRS but only if the borrower qualifies for them. Box number 5 and 7 have all the information required to know if the exemptions and exclusions apply or not.
Responsibility Of The Taxpayer: The person who received the 1099-C form has to report the cancelled debt income into their tax return. You can always try to determine if any exemptions or exclusions apply to your case or not. If not, then you have to pay the tax amount because neglecting it can come with severe consequences.
Exemptions: When You Don’t Owe Taxes on Settled Debt
Mostly, forgiven debt is taxed by the IRS but there do exist multiple different important exemptions that can save you from paying the tax on the canceled debt. It’s important to understand these exemptions as they can save you from unexpected taxes and probably thousands of dollars.
Here are a few exemptions where settled debt won’t be taxed by the IRS;
1-Bankruptcy
Under Chapter 7, Chapter 11 and Chapter 13, any debts discharged will not be considered taxable. If you filed for bankruptcy and got your debt discharged as a result of it then you won’t have to worry about paying any taxes. However, to report the exclusion you still would need to file for Form 982.
2-Insolvency
Another exemption is when you were insolvent when your debt was forgiven. Insolvency means that your total debt exceeds the total value of your assets. In such a situation, if any lender forgives a portion of your outstanding amount then it won’t be considered taxable. In order to claim this exemption, you’ll first have to fill out the Form 982 and provide proper proof and documentation of your financial situation.
3-Certain Student Loans
Any student loan that’s forgiven due to death, any disability or under some certain public service loan forgiveness program will not be considered taxable. For example, if your federal loan has been discharged under the Public Service Loan Forgiveness program or through any other income driven repayment plan then you won’t have to pay any taxes on the forgiven amount.
4-Mortgage Debt Forgiveness
Certain individuals can exclude the forgiven mortgage debt but only under specific circumstances like foreclosure or any loan modifications. This exclusion is a part of the recent legislation but it’s important that you first check things up with the IRS website to ensure the year of tax in question.
5-Real Property Business Debt Or Some Qualified Farm Debt
If you are in debt due to your farming business or your real property that’s been used in business then you might not have to pay any tax on your forgiven amount.
How to Minimize Your Tax Liability on Forgiven Debt
Even though the cancelled debt is almost always taxed by the IRS, there still are some exceptions and strategies that you can use to at least reduce the tax liability. It’s best to know about your options ahead to protect yourself from a whooping income tax bill.
Here are some effective ways to minimize your tax burden;
1-Learn If You Qualify For Tax Exemption
Before you pay any income tax on your forgiven debt, it’s important that you learn about the exemptions by the IRS. Check if you qualify for any of the exemptions like insolvency, bankruptcy, certain student loans and sometimes principal residence debt too. If you do qualify, you should use the 982 IRS form to claim the exemption.
2-Consult With A Tax Professional Before Time
You can always use advice from a qualified tax professional who knows the ins and outs of the IRS tax rules, its complexities and the exclusions. Your advisor can even help you fill out your forms properly to avoid any future problems. This is an important tactic because it’ll help you prepare yourself for the tax impact of your debt settlement.
3-Proving Insolvency
One of the most common ways to eliminate your cancelled debt tax is to demonstrate insolvency to the IRS. Insolvency is when the total amount of your debt is greater than the total value of your assets and your lender forgives the outstanding amount. That forgiven amount won’t be taxed by the IRS. All you need to do here is to gather all the necessary information you can, provide proper documentation and give proof of your financial situation.
4-Always Check With The State Tax Rules
Sometimes, the IRS doesn’t tax your forgiven debt but your state does. This is why it’s of utmost importance to always check your state rules regarding cancelled debt. For this you can take some help from the local regulations or directly talk to your tax professional for assistance.
5-Make Sure Your Records Are Accurate
Whenever you negotiate a debt settlement, make sure that you are getting everything in writing. You are supposed to have all the documentation prepared, including your debt cancellation information, your settlement agreements, your 1099-C form and your proof of bankruptcy or insolvency. Everything is important especially when the IRS calls you up for some questioning regarding your filing.
Debt Settlement & Insolvency: How It Affects Taxes
Settling a debt for less than what you owe means you are obliged to pay income tax on the forgiven amount of your loan. However, there’s an important exclusion to remember here and that is the exclusion of insolvency. Insolvency refers to the fact that your total loan amount exceeded the total value of your assets which is why you opted for a settlement for the remaining amount. If such is your case then you can file the IRS form 982 and explain your financial situation in detail during the time of the settlement. With this exemption, you can either reduce your tax amount or get it cancelled completely.
For example, if you had a loan of $50,000 and your total value of your assets was $35,000 when $20,000 of debt was forgiven. In such a case you can get the $15000 of the forgiven debt excluded but you’d still have to pay tax on the remaining $5000. Now if you want to claim this exclusion, you just file the 982 form along with your tax return. Moreover, to prove insolvency, you’ll have to provide calculations and detailed documentation of your financial situation at the time of settlement. For this, it’s best if you prepare a detailed balance sheet that includes your assets along with your liabilities.
Professional Guidance Is Of Utmost Importance
The whole tax terms regarding settlement and insolvency are a little complex and it’s best to use professional guidance to avoid misreporting. If you fail to file the necessary forms, you’ll face consequences like penalties, IRS audits and unexpected taxes. All you need to do is to get some help from a qualified tax professional to ensure that you are taking the right path forward.
What to Do If You Receive a 1099-C Form
Receiving the Form 1099-C (Cancellation of Debt) can be a little confusing initially especially if you weren’t aware of the tax implications in a debt settlement. If you receive the IRS form, it means that the forgiven loan by your creditor is taxable and here’s what you need to do if you get one;
Never Ignore It: Your creditor sends the Form 1099-C to you and the IRS too so ignoring it won’t be an option. If you fail to take immediate action after receiving the form, you’ll face consequences, interests, penalties and sometimes additional taxes too. Even if you disagree with the form, you have to do anything about it because neglecting it will just worsen your situation.
Verify All The Information: The next step is to ensure that all the information mentioned on the form is correct. It includes the name of the creditor, the cancelled amount, the date of settlement along with the code for the reason of settlement. If you see anything wrong with the form, contact your lender immediately and ask for another corrected form.
Determining If You Really Owe The Tax: Cancelled debt is taxable but there are a few exemptions by the IRS. For example, bankruptcy, insolvency or student loan forgiveness, all these scenarios mean that you don’t have to pay any income tax on the forgiven amount. If that’s the case then you should file the IRS form 982 immediately and qualify for the exemption.
Calculate Insolvency If It’s Applicable: In case you were insolvent at the time of settlement, you have to report it to the IRS to cancel the tax amount. For this, you have to list down your debt, the total value of your assets and your financial situation at the time you settled your debt.
Consult A Tax Professional: Dealing with the IRS and tax matters requires proper professional consultation. If you don’t know a thing about taxes then it’s best to hire a tax professional because any mistake you make during the process can cost you a lot. Whether you are unsure if you qualify for tax exemption, were insolvent at the time of settlement or have received multiple IRS 1099-C forms, a tax consultant can really come in handy to you in such situations.
The Takeaway
Receiving a 1099-C form doesn’t always mean that you owe the IRS any tax income. However, it does mean that you have to take action immediately because neglecting the form will just wreak havoc on your financial life. When you get the form, read it carefully, review it for any mistakes and check all the information about tax exemptions. If you qualify for an exemption, file the 982 form with the IRS and report it to them immediately. This won’t just cut down your tax cost in fact, it might even fully cancel it. Again, to protect yourself from any complicated tax trouble, it’s important that you work with a tax professional first. These people are highly qualified and they know the in and out of the IRS and forgiven debt so it’s best if you work with them.
FAQs
Q1. Why Is Forgiven Debt Considered As Income?
When you borrow money from a lender, it’s not considered taxable because you are expected to pay it back in full. However, if for any reason your lender has forgiven some amount of your debt or if the debt obligation has been discharged then the IRS views it as financial gain which is why they put tax on it.
Q2. What Is The IRS Form 982 And How Should I Use It?
The IRS Form 982 is specifically for those who want to report and justify why their debt was forgiven. If someone qualifies for an exemption like insolvency or bankruptcy then they won’t have to pay any tax income on the forgiven amount. To protect yourself from any unwanted taxes, it’s important that you file the form immediately after receiving the 1099-C Form.
Q3. Can Someone Dispute The 1099-C Form If It’s Incorrect?
Yes, you can always dispute any errors or mistakes in your form with your creditor. Just contact your creditor and tell him about the errors in the form and request for another corrected form. Ignoring any errors and not disputing them timely can cost you a lot of trouble. If you are seeking professional debt settlement services that’ll guide you through the tax implications in a hassle free and seamless way then try Mountains Debt Relief. Our professional services can help you regain your financial control.