Debt Settlement and Income Tax Liability

Many people may land into debt after using credit cards. Whatever the cause may be, if a person is knee deep in debt, he/she can always consider two options, one is debt settlement and the other is declare bankruptcy. Debt settlement, also known as debt negotiation, is a legal and ethical way to get out of debt fast.

In a debt settlement, the creditor or the money lender (usually banks and other financial institutions) negotiate with the debtor and reduce the outstanding debt amount to about 40-50 percent of the total owed money. The percentage of debt settlement may vary; it can be as low as 20-30 percent or as high as 70-80 percent, depending upon the financial condition of the debtor and the internal settlement policy of the creditor. The amount forgiven under debt settlement is called cancellation-of-debt (COD).

The debtor can arrange for a debt settlement on their own or hire debt management professionals. Advantage of hiring professionals is that they are well-informed about the lender and their allowed debt settlement amount. However, while hiring a professional, one should ascertain the fee that they charge. Some of them may charge as much as 35 percent of the amount that has been reduced under the program.

Debt settlements have many benefits such as lowering the monthly payment, waiving of late fees, reduction in the interest rate and most importantly, avoiding bankruptcy. It helps a debtor become debt free. Though, there is no doubt about the various benefits of debt settlement, many people are unaware of the fact that income is taxable on COD, as per the guidelines of Internal Revenue Service (IRS). Under the IRS norm, the creditor is required to report the forgiven amount in Tax Form 1099-C, in case the forgiven debt is $600 or more. For this reason, debtors and debt counselors do not opt for debt settlement.

However, a debtor may be exempted tax on the forgiven debt, if he/she is proved to be insolvent when the debt was settled. The term 'insolvent' indicates having a negative net worth. To be more precise, a negative net worth means that the liabilities (debt) of the debtor is more than the assets. Let's take an example, if the home (or other property) equity of the debtor outweighs the total liabilities, then he has a positive net worth and should pay the tax on the forgiven debt. In case, the debtor does not understand the insolvency rule, he/she can refer to the IRS Publication 908 for more information or consult a tax professional.

Whatever may be the income tax consequences, the debtor should not refrain from opting for a debt settlement. It is to be noted that with a debt settlement, the debtor is saving a significant amount of money. In case, one continues to pay the minimum monthly outstanding bill, then he/she will end up paying interest up to 25-30 percent of the debt amount. One should always remember that the amount paid to the creditor plus the income tax liability, is still lower than the total debt amount.