Mary Grace McCormick, Credit Writer
@mg_mccormick
Yes, you do have to pay taxes on a debt settlement. The IRS views the portion of your debt forgiven after debt settlement as income and therefore taxes you on it. Forgiven debt (also known as canceled debt) is taxed at the same rate as your federal income tax bracket.
When you have $600 or more in forgiven debt, your creditor will send a Form 1099-C to you and the IRS stating your forgiven debt. Whether you receive a 1099-C or not, it’s important to report your forgiven debt as income. The IRS will match what your creditor reports as forgiven debt against your tax return, so if you don’t report it, they will send you a notice.
There are two important exceptions to the reporting requirement. The first relates to insolvency, which occurs when your debts are greater than your assets. Another exception involves debts forgiven through bankruptcy.
Notable Exceptions to Reporting Forgiven Debt as Taxable Income
Exception 1 – Insolvency: If you were insolvent before your debt was settled, you only need to report the portion of forgiven debt greater than your net worth.
For example, let’s say you have you have $20,000 in assets and $30,000 in debts for the year 2023. This means your net worth is $10,000.
During the year, you had $15,000 of debt forgiven. This means you have $5,000 of net forgiven debt. This is reported on Schedule 1, line 8, which is then reported on Form 1040, line 7a. The remaining $10,000 in forgiven debt is reported on Form 982, line 2.
Exception 2 – Bankruptcy: If your settled debt was canceled in a bankruptcy case, you do not need to report it as taxable income. You do, however, need to report it on Form 982 to show your debt was cancelled.
For other exceptions, you can reference IRS Publication 4681.
Bottom Line
The IRS taxes the forgiven portion of debt that results from the debt settlement process. This portion is taxed at your federal income tax rate and is reported on Form 1040, line 7a.
If you had $600 or more in forgiven debt from a creditor, you will receive a 1099-C from them. Always report your forgiven debt as income, even if you do not receive a 1099-C. If you don’t report it, the IRS will send you a notice.
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