The Hidden Tax Costs Of Debt Settlements

At first blush, debt settlements sound great.

"You can pay off your existing consumer debt for less than 50 cents on the dollar!" is what a lot of debt negotiation companies will tell you. Are they telling the truth? Well, yes they are.


Before you go running out and hiring one of these companies to slash that $20,000 credit card debt in half for you, consider this.

If the amount that you save is greater than $600, there is a possibility that the creditor may report the amount of these savings attributed to any debt settlements to the IRS as "Discharge of Indebtedness" income. What does this mean? It means that you may have to claim the amount of your debt savings on your income tax return as income.

For example. Let's say that you did have $20,000 in credit card debt. You hire a company to settle your debts for you. After 12 months of negotiation, they manage to get the credit card company to agree to a $7,000 settlement of the account. Over these twelve months you have been able to save up the $7,000 and you use this to settle the debt. Now, the good news is that you saved $13,000 (less fees paid to the debt negotiations company of course)! The bad news is that you may have to claim that $13,000 as income.

If a creditor has forgiven over $600 of monies owed to them by you, they will likely send you a form 1099-C at some point before your taxes are due.

Sidebar: I strongly urge that you consult a CPA or tax attorney to ascertain what ramifications debt settlements would have on your tax position. You may also want to visit the IRS website at or more information on how your taxes may be affected.

Can You Avoid Paying Income Taxes On The Amount You Save By Settling Your Debts?

Again, I urge you to consult a tax professional, but, if you are insolvent (your total debts outweigh your total assets) you may be able to exclude the Discharge of Indebtedness income from your reportable income. This is what I understand to be true, but check this out for yourself and see how it might pertain to your particular situation.

Another thing you could try is to request as part of the settlement agreement that the creditor not report the debt savings to the IRS as Discharge of Indebtedness income. I am not suggesting anything illegal here, nor am I suggesting you ask the creditor to do anything illegal. Again, it is my understanding (and you should verify with a tax attorney or CPA) that if the creditor doesn't report the debt savings to the IRS as income to you then you will not have to pay income tax on it.

If you would like answers to questions like this that pertain to debt settlements, but you don't have a CPA or tax attorney that you know (or want to pay!), a good option would be to this. Contact a debt relief company that offers settlement as an option, and as part of the initial free consultation ask as many questions as you can.