Navigating Taxes on Settled Debt: What You Need to Know

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How Debt Settlement Works

Debt settlement involves negotiating with creditors to accept a payment that is less than the total amount owed. This can be done directly with creditors or through a debt settlement company. While creditors prefer full repayment, they may agree to a settlement to avoid sending the debt to collections or to help you avoid bankruptcy.

Working with a debt settlement company can be risky, as some companies may use tactics that harm your credit. Additionally, you will likely need to pay fees to the debt settlement company, and any reduction in your debt is considered income by the IRS.

What Are the Tax Implications of Debt Settlement?

The IRS treats canceled or forgiven debt as income, similar to wages or interest earned. For example, if you settle $5,000 in credit card debt for $1,500, the IRS considers the $3,500 forgiven as income.

If a creditor forgives $600 or more in debt, they will issue a Form 1099-C, which is sent to both you and the IRS. You must report the canceled debt on your tax return using Schedule 1: Adjustments to Income and Additional Income. Enter the total amount of canceled debt on line 8c and report your total Schedule 1 income on line 8 of Form 1040.

How Much Is Settled Debt Taxed?

Settled debt is taxed as ordinary income, based on your tax bracket and marginal tax rate. For instance, if you earn $75,000 a year as a single taxpayer, your top marginal tax rate is 22%, so any additional income from settled debt will be taxed at 22%.

How Do I Know if I Owe Taxes From Debt Settlement?

Keep records of any settled debt to calculate the amount of canceled debt for tax purposes. Compare your calculations with the canceled debt reported on any 1099-C forms issued by your creditors. Even if you do not receive a 1099-C for debt less than $600, you should still report the canceled debt on your tax return.

Exceptions to Canceled Debt

The IRS provides exceptions for certain canceled debts, which are not considered taxable income. These include:

• Debts canceled as gifts, bequests, or inheritances
• Qualified student loans with cancellation provisions based on employment in certain professions
• Some student loan discharges made between December 31, 2020, and January 1, 2026
• Amounts received or forgiven under certain student loan repayment assistance programs
• Amounts of canceled debt that would be deductible if paid as a cash basis taxpayer
• Qualified purchase price reductions given by the seller of property to a buyer

Excludable Debts

The following settled debts do not need to be included in your taxable income:

• Debt canceled in a Title 11 bankruptcy case
• Debt canceled due to insolvency
• Qualified farm indebtedness
• Qualified real property business indebtedness
• Qualified principal residence indebtedness discharged before January 1, 2026

The Bottom Line

While accounting for settled debt on your tax return is straightforward, it is wise to consider your tax bill early in the debt settlement process. If finances are tight, paying taxes on settled debt might be challenging. Estimating your tax liability based on your tax bracket and marginal tax rate can help you plan ahead. Consulting a tax professional can also be beneficial.

If you have recently settled debt, it is important to check your credit score, as debt settlement can negatively impact your credit. Monitoring your credit score can help you understand the effects and take steps to rebuild your credit over time.

For any mortgage service needs, contact O1ne Mortgage at 213-732-3074. We are here to assist you with all your mortgage requirements.

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