Debt Settlement Taxes Explained: What You Need to Know

Debt settlement sounds like an attractive solution to a serious financial problem, but in addition to being difficult to negotiate, debt settlement often comes with another complication — taxes. All the money you no longer have to pay to creditors? The Internal Revenue Service considers it income, and you’ll likely have to pay taxes on it.

What Is Debt Settlement?

Debt settlement is a negotiation with creditors that results in you paying less than what you owe. You can do it yourself or pay a reputable debt settlement company to negotiate the deal for you.

Creditors agree to debt settlement when it’s clear that if they don’t take less than what’s owed, they’ll likely get nothing. You, or a debt settlement agency, negotiate a lump-sum payoff that’s less than your balance.

You win by reducing your debt burden. But debt settlement also has disadvantages.

Turning to debt settlement means admitting you can’t meet your financial obligations. Not fully paying what you owe is a red flag to creditors, as well as the Internal Revenue Service, which considers debt relief taxable.

The fact that you didn’t pay the full amount owed will appear as a negative on your credit report for seven years, lowering your credit score. The red mark on your credit report and lower credit score will make you less financially flexible.

You likely will have to pay late fees and interest charges to your creditors while you build the lump-sum settlement amount. Creditors are not obligated to negotiate or accept a settlement.

For-profit debt settlement companies will also charge a fee for the service. You also likely will owe federal taxes on the canceled debt if it’s more than $600. The IRS considers forgiven debt to be taxable income. Many states also have laws regarding taxation of debt forgiveness.

As you weigh the pros and cons of debt settlement, consult a financial advisor or a credit counselor from a nonprofit agency like InCharge Debt Solutions to understand all the ramifications of how debt settlement will affect you.

Do You Have to Report Settled Debts?

Your creditor — or a debt collector — will send you a Form 1099-C that shows the amount of debt canceled the January after your settlement closes. You include the form when you file your federal taxes, as well as your state taxes if you live in a state with an income tax. Creditors are required to send a 1099-C for canceled debt of more than $600, but even if they don’t, you’re still required to report the forgiven amount on your tax return.

There are exemptions, including some student loan debt. You can find more information about exemptions from IRS Publication 4681.

Debt Settlement Tax Consequences

You likely will be charged taxes on the forgiven amount of debt after a debt settlement. The IRS considers any debt cancellation of $600 or more as additional income — and taxable — even though you didn’t actually receive any money. It’s income because it’s money you borrowed from someone – the creditor – but now don’t have to pay back.

For instance, if you owe $7,000 on a credit card, but settle for a $4,000 lump-sum payment, you now have $3,000 in taxable income.

Each creditor or debt collector that settled will send you a Form 1099-C, which shows the amount of debt canceled by that creditor, and when it was canceled. Creditors also file 1099-Cs with the IRS. So, the IRS gets the information from both you and the creditor.

If you live in one of the 41 states with a state income tax, you may also have to pay taxes on the forgiven debt. Each state has its own rules, and they may differ from the IRS. If you’re wondering how to avoid paying taxes on canceled debt, there’s really no good way unless you qualify for an exemption. Failure to report your forgiven debt could result in tax penalties and interest charges, both at the federal and state levels.

How Are Taxes for Debt Settlement Calculated?

The amount of canceled debt is added to your income and becomes part of the calculation for your taxable income. That amount includes earned income, other additional income, deductions, credits, exemptions and filing status.

How much specifically you have to pay on canceled debt depends on many factors, but the biggest one is your tax bracket.

You may be able to reduce or eliminate the extra tax liability by being smart about deductions and tax credits. In extreme cases, you can claim an exclusion or exception, such as insolvency, bankruptcy, or qualified principal residence indebtedness.

It may be worth hiring a tax professional to do your taxes and help you squeeze out the best tax payment.

Tax Exemptions for Canceled Debts

One way to avoid paying federal taxes on canceled debt is to qualify for an exemption. Exemption rules change, so it’s important to check the details on the IRS website and make sure you qualify. They also may not apply to your state income tax.

IRS exceptions and exemptions to taxing debt settlement income include:

• The debt was canceled as part of a Chapter 7, Chapter 11 or Chapter 13 (You may have to reduce some of your tax credits by the amount of the canceled debt.)
• The debt was canceled as a gift, inheritance, or bequest
• Student loan debt canceled between Jan. 1, 2020, and Dec. 31, 2025, as part American Rescue Plan student loan forgiveness
• Student loan forgiveness as part of the Public Service Loan Forgiveness (PSLF), Teacher Loan Forgiveness (TLF), or other federal student loan forgiveness programs for individuals in certain professions who are employed for a specific amount of time.
• Debt canceled under educational loan forgiveness programs for providing health services in certain areas, including the National Health Service Corps (NHSC) and the Nurses Corps Loan Repayment (NCLR) programs.
• Debt canceled as part of a federal student assistance Income-Driven Loan plan.
• You can demonstrate that you were insolvent at the time your debts were canceled.
• The canceled debt was less than $600.
• The canceled debt would have been a deductible item for the borrower.
• The canceled dent was from a non-recourse loan (typically used in real estate transactions).
• You were a qualified farmer, and the canceled debt came directly from your farming business.

If you qualify for an exception or exclusion, you don’t need to report your canceled debt on your tax return.

Alternatives to Debt Settlement

Debt settlement may look like a great solution for discharging your debts fast, but it can also damage your credit score, increase your tax liability, and cost you money through high charges and fees.

You may want to consider alternatives to debt settlement, including:

• Bankruptcy. A legal process that eliminates or restructures your debts under court protection. The IRS doesn’t usually tax debts discharged through bankruptcy. And you may be able to retain your assets and repay some creditors over time depending on your bankruptcy.
• Credit Counseling. A nonprofit service in which you work with a certified credit counselor to create a budget and enroll in a debt management plan. A credit counseling session can also help you learn how to better manage your finances, improve your credit score, and learn about debt relief options available.
• Debt Management Plan. A nonprofit credit agency works with your creditors to lower interest rates and fees, and you make one monthly payment to the agency until your unsecured debit is paid off. Debt management plans usually take 3-5 years and help improve your credit score.
• Debt Consolidation Loan. A debt consolidation loan combines multiple debts into one loan with manageable terms, a lower interest and a specific repayment term. Although you can lower monthly payments and interest fees, it doesn’t lower the amount of debt. Debt consolidation can damage your credit score temporarily, but it doesn’t increase your tax burden.

Speak to a Credit Counselor About Debt Relief

Each alternative plan has pros and cons. If you’re torn between debt settlement vs. credit counseling or wondering whether debt consolidation or debt settlement will work best for you, talk to a credit counselor or financial advisor.

A certified credit counselor can help you assess your overall financial situation, create a realistic budget and work with your creditors. A counselor can also enroll you in a debt management program to pay off your debts, in full, with lower interest rates and fees.

Credit counseling is a valuable service that can help you get out of debt and stay out of debt. By speaking to a credit counselor, you can learn how to manage your money better, avoid falling into debt traps and achieve your financial goals.

Credit counseling is usually free or low-cost, and you can do it online or over the phone. Choose a reputable credit counselor certified by the National Foundation for Credit Counseling (NFCC).

Speaking with a Tax Professional to Understand Your Options

If you’re concerned about debt and taxes, it’s a good idea to talk to a tax professional. A tax professional will charge a fee, but they will help you untangle complicated tax concerns, find deductions and credits you may not know you qualify for, and likely save you money. They can also help you avoid a future audit, and the penalties and fees that come with not paying what you owe. If you speak to a tax professional, make sure they are a licensed tax professional. The IRS has a directory of federal tax preparers, searchable by state, that includes what their credentials and qualifications are.