Forgiven Debt Isn't Really Forgiven At All

By Kate Luther. Last updated 22 September 2009. 12 comments

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.

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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.

 

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Guest's picture
Colin

In a progressive tax system, such as in the US, the tax on forgiven debt will always, always, always, be less than the amount of "income". It's not like the $600 in forgiven debt will cost you $50,000 in taxes.

Regardless, the tax on whatever is forgiven will always be less than the forgiven debt itself. Granted, if you don't have the money to pay the debt means you probably don't have the money to pay the taxes on the forgiven debt but the end dollar amount will be cheaper.

Guest's picture

This is great information for anyone who is struggling with credit card debt. It can be overwhelming and finding a way to get back on your feet without completely ruining your credit isn't easy. Thank you for this information.

Guest's picture
some guy on the internet

This article seems to defy logic.

I think paying taxes on the 60% of what is being forgiven is still a great deal. I think having your cake and eating it too is out of the question. If the IRS takes 30% of the windfall, so be it. You are still better off then when you started.

If the point of the article was as a heads-up for tax time, then good job. Another heads-up should be all those people who used the cash-for-clunkers program and don't realize they have to pay taxes on that too.

Guest's picture
Barry

Yes the credit card company can issue the cancellation debt form to you. The problem is that they do it when they cancel the debt off their books. And there is no time limit. Even if your debt was canceled this year, the year they cancel the debt could be next year, or even 5 years from the debt cancel year. It could come in any year, but it will probably come. The tax is due for the year you receive the form, not the year the debt is reduced.

Guest's picture

Have to agree with the comments that say it's still a good deal!

A factor that may weigh in your favor in regard to taxes is that debt foregiveness often occurs in years when income is minimal--which is one of the reasons a creditor might settle for less in the first place. If you're income was minimal you may only be in the 10 or 15% tax bracket.

$5000 in foregiven debt will only cost $750 in extra taxes if you're in the 15% bracket. That still leaves a net foregivess of $4250 ($5000 less the 750 in taxes). That's a deal no matter how you look at it.

Good post, though. I doubt most people are remotely aware of the tax consequences of debt settlments. It can be a nasty surprise when those 1099s start arriving in the mail.

Guest's picture

There is a little-known rule with the IRS that if you are insolvent, you won't need to pay taxes on it. The IRS did a mail-in audit for me because their original auditor did not realize we were insolvent, but once I sent in the paperwork, all was good and I did not have to pay taxes on the forgiven debt.

My recommendation is to do the research yourself on it or speak to an tax accountant about the specific.

Guest's picture
Kristin

I'm not in this predicament right now, but my younger sister's fiance is. If you took out federal student loans before 2006 (not sure if that's the right year) and if you're still paying on them 25 years later, they'll be forgiven. Does the income idea still apply to student loans? I'm positive that neither of them have thought of this and I don't want my sis to get in any more financial problems than she already is in. Thanks for the info.

Guest's picture
Tracy

OUTSTANDING advice! So many people are not educated about the pitfalls of debt-settlement before somebody convinces them that it is the answer to all their problems.

Thank you for posting this excellent resource!

Guest's picture
Guest

If you are insolvent, then you can complete and submit IRS tax form 982 with your tax return and you will not have to pay this tax. Someone who is considering debt settlement should be insolvent, otherwise they should pay the tax, which they still save more money than paying 100% of their debt, plus the interest during that time.

Guest's picture

Wow, amazing advice. It's hard enough to get out of debt without everyone from the government to "debt consolidation counselors" trying to trick you. I guess the best advice is to seek out advice that you trust, rather than thinking there's a way to get out of debt without paying it all off. I think the best thing is usually to work with the creditor directly, but that's easier said than done. The old adage is true: everything has a string attached.

Guest's picture

There is no doubt that a settlement is a great tool for getting out of debt. It can make the difference between bankruptcy and digging out the hard way. The creditor gets to write off the loss (which isn't as good today since many banks aren't profitable), the debtor claims it as income unless an exception is granted, and bankruptcy is often averted. It's GREAT!

Beyond the obvious savings of not paying the entire balance, it also severely hurts your credit score which is a good thing. If you're this deep in debt, the last thing needed is another loan.

For those pursuing something like this, a few tips: (1) don't think settlement until you have money available at the bank, (2) contact all of your creditors to find the best settlement, (3) be nice and honest about your situation with the creditor, and (4) set aside some money for the tax bill. When I worked at Citibank years ago, settlements were routine so don't feel bad about not paying the full balance. Each creditor knows where their breakeven point is and usually by the time a settlement is available, a hefty portion of the balance is interest and fees anyway.

Most companies will entertain settlements if you're 3 months or more behind on your bills (with them or with others). Also, NEVER use a debt settlement company...it's safer and cleaner to do it on your own.

Guest's picture
Bob

I wish what you wrote was true in all cases. My bank forgave half my SBA loan but now the US Dept of Treasury is trying to collect 100% of the debt taking money from my tax returns. I filed a dispute but they tell me it is up to the SBA. The SBA tells me that a 1099-C is just a formality used by the banks to get debt off their books. They expect to get paid on 100% of the loan even though they only paid out 50% of the loan!

This is government at it worst ignoring laws that are honored by private companies!