Is Debt Settlement Money Taxable Income?

When you enroll in a debt settlement program, you may owe taxes on the debt that’s cancelled. The IRS (Internal Revenue Service) requires companies to report any amount of cancelled debt that exceeds $600 to them and to the debtor. They consider cancelled debt a loss to the creditor and income to the debtor. So, when it’s time for you to file income taxes in the next tax year, you’ll have to include the amount of the settled debt as income.

 

 

Certain businesses are required to send you IRS Form 1099-C for Cancellation of Debt when the amount cancelled exceeds $600. This includes federal government agencies, financial institutions, and credit unions. Though you generally have to report cancelled debt to the IRS, there are four situations when you don’t have to.

1. When the Debt Was an Error

Under the Fair Credit Billing Act, you have the right to dispute credit card billing errors. This includes fraudulent charges that you didn’t make as well as clerical errors made by the credit card issuer. However, you may have to use the court to enforce the rule if the credit card company won’t budge. This process is called a battled contest. If you ultimately end up settling the debt with the credit card company to keep the court battle from going on indefinitely, you won’t have to include the cancelled debt in your income taxes.

2. You Went Bankrupt

You may have all or part of your debt cancelled through Chapter 7 or 13 bankruptcy. Fortunately, you don’t have to report debt that was discharged in bankruptcy as long as the debt was cancelled your local bankruptcy court.

3. You Were Insolvent

As defined by the IRS, you are insolvent when your liabilities (what you owed to someone else) exceed the fair market value of your assets. If you were insolvent immediately before your debt was settled, you don’t have to include the cancelled debt in your income by the amount that you were insolvent.

For example, let’s say at the time your debt was settled, your liabilities were $20,000 and your assets were $15,000. You were insolvent by $5,000. Let’s also say that the debt you owed; $10,000 to the creditor was settled for $6,000. In that case, you’re allowed to exclude $5,000 from the cancelled debt because that’s the amount you were insolvent by. The remaining $1,000 must be reported as income.

 

 

The burden of proof lies on you, though. It’s your responsibility to show the IRS proof that you were insolvent when the debt was cancelled. This is especially true if you receive a Form 1099-C from your creditor because the IRS will be looking for you to include that amount in your income.

4. The Debt Was Cancelled As a Gift

Lastly, if the creditor settled the debt as a gift to you, you don’t have to report the amount of the cancellation as taxable income.

Reporting Cancelled Debt

The IRS requires you to report cancelled debt whether you receive a Form 1099-C from the creditor or not. You risk a tax audit if the creditor sends a 1099-C to the IRS but you fail to include the cancelled debt on your tax return.