Beware of the Debt Settlement Tax - What to Look For, What to Do
If you’re still in debt, you’re probably thinking about talking to your creditors about settling your debts for less than you owe. Beware, though. What you probably don’t know about debt settlement is that it can have a great impact on your taxes.
If you negotiated a settlement with your creditors, you’re basically “earning” money from your debt. Here’s how it works: If you took out a loan for $10,000 and couldn’t pay it back, but negotiated with your creditors for them to accept $6,000 as full payment of your loan, you’ve pocketed $4,000 (the difference between how much you borrowed and how much you paid back). The IRS takes a close look at these kinds of loan repayments.
I’m sure that at one point, there was a loophole in the IRS tax laws that allowed for this to happen. Unfortunately, the IRS is quick to get wise about these types of things. Just like so many other tax loopholes, this one has been closed.
Just like in our example above, if you have credit card debt or any other kind of debt, you will likely be held liable for any “profit” that you realize as a result of settling your debt for less than you owe. Keep this in mind when it comes time to prepare your taxes after debt settlement.
Although this may sound like a bad thing to you, you’re still ahead of the game after taxes. In our example, the $4,000 “gain” you realized may be taxed at 30% (which depends on your tax bracket), meaning that you owe a $1,200 tax. Even after the tax, though, you’ve still only had to pay $7,200 to settle a $10,000 debt. You’ve gotten a 28% discount, which is a bargain in my estimation.
Since the debt settlement tax is so little-known to most people, they usually don’t do anything about it until after an IRS audit. Keep it in mind, and don’t let this tax take you by surprise.
If you’d like more details on how this tax applies to your specific situation, please consult with a CPA or other tax professional.
