Forgiven Debt is Taxable Income

By: Timothy McFarlin | Published: March 21st, 2013 | Category: Bankruptcy, Budget & Debts, Tax Planning

Surprising news for many American consumers out there: Forgiven debt is taxable income!

When you’re buried in debt, the one saving grace is often creditor settlement. Creditors are often willing to negotiate a significant discount on a debt when they know that a consumer is unable to pay in full. The rationale is that they would rather get reimbursed for some of the amount owed than not get paid at all.

Many Americans, especially those saddled with debt, likely know this. However, when consumers strike a deal to settle a debt with a creditor this way (and millions did last year), there’s often a significant hidden cost that consumers don’t know about until the IRS comes knocking.

The IRS views your forgiven debt as taxable income if you saved more than $600 by settling your debt with a creditor. For example, let’s say that you owe a creditor $10,000, and you settle the account for $7,000. In this case, $3,000 was forgiven debt. The creditor is required to report all settlements with forgiven debt that exceeds $600. Therefore, the creditor must submit a 1099-C form and send a copy to you. If you’re in the 15% tax bracket, then you owe the government $450.

It’s not hard to understand why so many consumers miss this. If you never receive cash from a creditor, the forgiven debt certainly doesn’t feel like income. Furthermore, many creditors do not disclose the possible tax liability during settlement negotiations. For if creditors did disclose, then the consumer would likely push to settle for a lower amount. And since there’s no law requiring them to disclose the tax liability, they likely will continue withholding this information.

When consumers receive a 1099-C form in the mail referring to a past creditor or debt settled, they often assume it’s trash or an old mailing that can be disregarded. If you receive a 1099-C form in the mail, read it carefully. This is not a form to throw away. And sometimes, these forms aren’t always accurate. Some observant consumers have found that these forms often reflect entire debts owed instead of the forgiven amounts. You always have the right to dispute the form if you believe that any information is incorrect.

If you’re dealing with a large debt, negotiating settlement with creditors, or considering filing for bankruptcy, McFarlin LLP is here to help.

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