In general, if you have debt-cancellation income because your debt is canceled, forgiven, or forgiven for less than what you must pay, the amount of the debt canceled is taxable and you must declare the canceled debt on your tax return for the year the cancellation occurred. However, cancelled debt is not taxable if the law specifically allows it to be excluded from gross income. These specific exclusions will be discussed later. Legally, you must declare all the taxable income received and this includes the amount of the settlement of your debt.
If you are issued a 1099-C, the IRS will also receive an income notice and you may be penalized for not reporting. You'll have to pay not only the taxes you owe, but also the penalties. Requesting the insolvency exclusion involves completing a form that details all of the taxpayer's liabilities and assets (see IRS publication 468). The IRS allows taxpayers to exclude debts canceled by an amount equal to the amount that their liabilities exceeded their assets.
Once your debt has been settled, you'll make a single monthly payment, which will hopefully be a more manageable amount to the debt settlement company rather than to each individual creditor. If your debt is forgiven or is forgiven for an amount less than the total amount you owe, the debt is considered cancelled for the amount you don't have to pay. It feels great to have your debt settled, canceled, or forgiven, but you should keep in mind that debt settlement has tax implications. For major debts, such as student loans, tax-free debt forgiveness can really help your financial situation.
Therefore, it's critical to correctly file your state and federal taxes for any year in which you pay off a debt. Knowing the types of canceled debts you can exclude and properly reclaiming them on your return can reduce the penalty. Your ordinary debt cancellation income is the amount of debt that exceeds the FMV of the property that the lender forgives. Amounts that meet the requirements of any of the following exceptions are not considered debt cancellation income.
You must declare the debt forgiven on your taxes and your creditor will send you a Form 1099-C that will indicate the amount that was canceled and the date it was canceled. Your responsibility to declare the taxable amount of the canceled debt as income on your tax return for the year the cancellation occurred does not change whether or not you receive the correct Form 1099-C. Even if you don't receive a 1099-C, the law may require you to declare the canceled debt as income. Amounts that meet the requirements of any of the following exclusions are not included in income, even if they are debt cancellation income.
If you have problems with your debts, one option is to turn to a debt settlement company, which can help you negotiate terms with your creditors and potentially reduce the total burden of your debt. For example, if the canceled credit card debt was due to bankruptcy, or if you can prove to the IRS that you owed a total debt greater than the value of your assets (house, car, retirement accounts, etc.), the income tax that applies to the liquidated debt can be a serious burden for taxpayers who are already in financial difficulty. However, when a lender cancels the debt, the IRS treats the amount of the canceled debt as if it were actually income.