Debt settlement can help you find debt relief, but it can also lead to increased tax liability. In other words, it can shrink the size of your refund or, even worse, you can end up owing the IRS. If you are considering debt settlement and have recently had some debt canceled, it’s highly likely you’ll encounter IRS Form 1099-C. So, it’s important to know what this form is and what you can do to avoid that increased tax liability.

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What is a tax form 1099-C?

IRS Form 1099-C is issued by a lender that has forgiven any balance you owe that you are no longer responsible for paying back.

When you cannot repay a debt, it may be possible to get the lender to settle for less than you owe. The lender or creditor essentially forgives part of the balance. Having your debt canceled may feel like a burden has lifted from your shoulders, but once that Form 1099-C hits your mailbox, you could be in for a rude awakening.

The reason you get Form 1099-C is because the IRS treats canceled debt as taxable income. It’s money you received that you are no longer expected to repay, and since it’s not a gift, it counts as income. So, when a lender or creditor cancels $600 or more of debt, they must issue a 1099-C.

This form shows the amount of debt forgiven. Creditors must issue this form even if the debtor is not required to report the amount as income. Moreover, 1099-C forms must be issued for the tax year that a particular debt was canceled.

When you’ll receive a 1099-C

Should your lender agree and accept less than the full amount you owed, they will issue a Form 1099-C. In some instances, a lender may automatically discharge a debt and send a Form 1099-C if they have decided to give up their collection efforts.

Even though lenders are only ever required to send 1099-Cs if a canceled debt is worth $600 or more, it is still your responsibility to report smaller canceled debt amounts as gross income on your federal income tax returns. You also may have to pay taxes on canceled debt, even if you fail to receive a 1099-C.

What to do with it

If you have recently settled a debt with a creditor or lender, you can expect to receive a 1099-C soon. It is important you make sure you receive a confirmation of the debt settlement or forgiveness. Why? Because you can match up your information with your tax form.

If you’ve received a 1099-C for a debt you were unaware was canceled, contact the creditor or collection agency to verify whether they canceled the debt. If they have not canceled the debt, you may need to take additional steps to ensure the process is complete.

It may also be a good idea to make sure the debt has not been charged off and sent to a different collection agency. You should only receive a 1099-C if the debt has been forgiven, settled, or canceled.

Filing it with your taxes

Now, once you have figured out whether you need to claim the income or not, you must incorporate the 1099-C into your federal tax returns. That income will be added with your other forms of income to determine how much you tax liability is for the year—i.e. how much you owe. Unfortunately, that could result in a reduction of your tax refund, or worse, it could mean that you owe the IRS money. And if you don’t pay it off immediately, it will turn into back taxes.

Filing for an exclusion due to financial hardship

When tax season comes around, many people who settled debts or had their debts forgiven will receive a Form 1099-C. And they will likely wonder if they need to pay taxes on the forgiven debt. According to the IRS, forgiven debt is equivalent to income because you enjoyed goods or services using credit with the benefit of not fully paying what is owed.

So, when a lender or creditor records a partial loss on money they lent you, the IRS expects you to treat the loss as “ordinary income.” Fortunately, there is a loophole in the form of the insolvency exclusion. Should you be insolvent when you reach a settlement with a lender, you can offset your 1099-C income up to the insolvent amount.

For example, say you owned $100,000 in assets the same year you were forgiven $40,000 in debt. Assume at the time you owed $160,000 in total debt, including the $40,000 forgiven. That means your net worth at the time you settled was negative $60,000. Therefore, you were insolvent by $60,000 and would not be required to pay taxes on the $40,000 forgiven debt that was reported via Form 1099-C.

However, to prove insolvency you will need to file a Form 982, the Reduction of Tax Attributes Due to Discharge of Indebtedness, with your Federal Form 1040 to claim an insolvency exemption.

Tip: Filing for an exclusion due to insolvency can be complicated. Talk to a tax professional to understand potential tax liability and how to qualify for an exclusion correctly.

Should tax liability stop me from settling debt?

Tax liability should not stop someone from settling their debts. However, you should be aware of the tax liabilities that can come with settling. If you are having trouble figuring your way around a settlement, consider working with an accredited debt settlement company.

A debt settlement company will most likely enroll you in a debt settlement program. From there, the team can help by evaluating your assets and liabilities to determine if you are insolvent. If you are, you should be able to qualify for an exclusion and avoid any tax liabilities.

Connect with a nationally accredited debt settlement company that can help you make an informed decision on whether you should settle.

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Article last modified on August 3, 2022. Published by, LLC