Forgiven Debt Isn't Really Forgiven At All
If you've been struggling with the rest of the economy, chances are you've been forced to rethink your financial priorities. And as a result, credit cards are often the first thing to go.
The good news is that once you get behind, many credit card companies will offer to "settle" your account, some for as much as just 40% of your original balance. And if you're looking at a large chunk of credit card debt, making it go away for 40% of its value sounds like a pretty good deal.
But before you write that check, there's a little detail you need to know: in many cases, credit card companies can report that unpaid amount to the IRS and – this is the kicker – you'll have to declare it as income.
Wait a minute, you're saying. We made a deal. I settled that account and I even have a letter from my credit card company saying it was "settled in full." I shouldn't have to pay anything else.
And to that extent, you're right... you don't have to pay anything else... at least not to the credit card company.
But using the same laws that allow the IRS to tax you on gifts and prizes, if the unpaid portion is more than $600, the IRS considers it to be income and that income is reported on a Cancellation of Debt Form 1099-C.
That means that while your debt with the credit card company has been satisfied, you may stil have to pay Uncle Sam for getting such a great deal.
For example, let's say you had a $2,000 debt that you settled for 40% or $800. Your unpaid balance – the amount the credit card company agreed to "forgive" – would then be $1200.
At the end of the year (or whenever they do their reporting), the credit card company would report that amount to the IRS as a "forgiven debt" and send you a 1099-C to file with your individual tax return.
Now, whether or not you'll actually pay taxes on that amount will of course, depend upon your individual situation and the amount of debt being forgiven.
For most, a $600 increase in income isn't going to make a big difference in your taxable income but a bump of several thousand dollars just might. And if you consider that the average household has just under $10,000 in credit card debt and access to almost $20,000, it's not hard to see where a generous "settlement" offer might be considered during hard times.
Fail to report this amount and you could set yourself up for an audit.
This rule does not apply to certain types of debts such as those resulting from VA benefits, qualified farm debt, debts canceled in bankruptcy. It also is not applicable to debts that have been charged off so if your credit card company has sold the debt to a collector and written it off as a "bad debt," they cannot report the debt as "forgiven" on a 1099-C.
So, what can you do?
While it's tempting to cut a deal with credit card companies, you may end up paying more than you bargained for. In addition, even though the credit card company notes that the account was "settled in full," that is not the same thing as "paid in full" and the difference will be noted on your credit report.
There are however, some alternatives. Most credit card companies would desperately prefer for you to get back on your feet and pay your bills so many are offering various payment programs to help you manage your debt while times are tough.
Also remember that a credit card company will hold your account for at least six months before writing it off so if you're only a few months behind, you may still be able to avoid the collection agencies.
Another option is to enlist the help of a consumer credit counseling agency. However, before you sign up, make sure the agency is reputable and be sure you understand how participating in the program will affect your credit.
It might take a little extra work on your part to get out from under your debt, but at least you won't have to pay Uncle Sam any more at the end of the year.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by any bank, card issuer, airline or hotel chain.