Debt Settlement and the facts of associated Income Taxes
Debt settlement has become a popular approach to resolving problem debts without having to file bankruptcy. With this approach, creditors agree to accept a portion of what you owe (usually around 50% or less) to settle the account, and the remaining balance is forgiven. This technique will certainly continue to grow in popularity now that the new bankruptcy law makes it tougher to fully discharge debts in a Chapter 7 bankruptcy. There are so many more factors now when trying to file for Chapter 7 or Chapter 13 Bankruptcy.
Traditionally, creditors are required to report canceled debts to the IRS on Form 1099-C. This rule applies on all debts that are forgiven within a balance of $600 or greater. Therefore, the possibility exists that you may owe taxes on the forgiven portion of the debt. For this reason, many financial writers, debt counselors, and attorneys are strongly critical of debt settlement, to the point where they actually recommend against it just because you might end up owing taxes. But the tax consequences of settling your debts are greatly over-emphasized, and this is a really just a minor issue at best.
First, even if you end up owing taxes on the forgiven balances, that's because you saved a lot of money off your original debts. If you sat down and figured out the total of what you paid the creditor, plus the taxes, the total will still be much less than what you owed to begin with. There is still a net savings. So it's hard to understand why this is viewed as a problem in the first place! With this said, it's very important that debt settlement companies are only providing this service to those who really do qualify and need the help.
Second, the great majority of people who settle their debts are not required to pay taxes on the forgiven part of the balance. That's because of the "insolvency" rule, described in IRS Publication 908, "Bankruptcy Tax Guide." Don't let the title fool you. You don't need to have filed a formal declaration of bankruptcy to take advantage of the insolvency rule.
Basically, 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.