The Tax Consequences of Debt Settlement

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Jill Bridges
Jill Bridges
December 19, 2018

  • Debt settlement can result in several different tax consequences, depending on the type of debt that is settled.
  • In certain circumstances, the IRS considers settled debt to be income, so you’ll subsequently have to pay additional taxes.
  • Failing to report settled debt can be very serious, and it may result in an audit if the IRS discovers the debt settlement.

If you’re struggling with significant debt, both debt settlement and bankruptcy can be appealing options to get a fresh start and recover your finances. Both offer debt forgiveness or debt discharge to eliminate your existing debt and relieve the pressure and stress.

Unfortunately, if you settled a debt with a creditor for a lower amount than what you owe, or if you have a debt that a creditor has written off, you could owe taxes on that debt. The IRS considers this forgiven debt as income, which makes you responsible for additional income taxes. As a result, you could find yourself free from your credit debt, but you may still need to address IRS penalties.

Learn more about the tax consequences for debt settlement and bankruptcy so that you can choose the right option for your needs.

The Tax Consequences of Debt Settlement

What Is Debt Settlement?

Debt settlement is an agreement between the creditor and the borrower in which both agree to a reduced amount of the total debt to consider the debt paid. This arrangement gives the borrower the advantage of paying less than the total amount owed. The creditor gets to recover some of the lost money, rather than having to write off the total debt as a loss.

Although this option is a great choice to help those in debt get back on track, debt settlement comes with its own costs. In addition to appearing on a credit report and possibly damaging your credit score, it also has tax consequences for the difference between the total amount paid and the total amount owed.

Tax Consequences on Debt Settlement

If a creditor writes off a debt after a specific period of time, such as years after your default, the creditor reports your forgiven debt to the IRS as lost income to lower its tax burden. This situation is also the case with a negotiated debt reduction; the creditor will report the amount that wasn’t paid as lost income.

The IRS wants to collect the taxes on the forgiven debt. Since you weren’t responsible for the total amount of your debt, the IRS considers your settled or forgiven debt as income and subjects that debt to income taxes.


The taxes owed on this forgiven debt also apply to foreclosures. You have to pay income tax on the difference between your original mortgage with your lender and what the property ultimately sold for, an amount known as the deficiency.

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The Mortgage Forgiveness Debt Relief Act of 2007 altered this rule for specific loans that were partially or wholly forgiven between 2007 and 2017, as well as potential debt discharged in 2018 if it was in written agreement in 2017. Below are some items you need to know:

  • This act offers tax relief for a deficiency that results from the foreclosure on your primary residence.
  • In the case of secured loans on your primary residence that were used to purchase or renovate your home, you may consider up to $2 million in debt. You won’t need to pay the taxes on the deficiency. This situation also applies to refinancing, but only up to the original mortgage principal prior to refinancing.
  • In the case of loans on additional real estate, if you default on your mortgage that’s secured by the property that isn’t your primary residence, you’ll owe tax on the deficiency.
  • In the case of loans secured by your property that were not used to renovate the primary residence, you’ll owe tax on the deficiency.

If you aren’t eligible for an exception with the Mortgage Forgiveness Debt Relief Act, you may still have tax debt relief options.


Legal insolvency occurs when your total assets are exceeded by your total debts. If you’re considered insolvent, your forgiven debt gets excluded from your taxable income, but only up to the amount you’re insolvent. This designation can significantly lower your tax burden on forgiven debt.

For example, you may have assets totaling $150,000, which may include your property, vehicles, investment accounts, retirement accounts, or any other assets in your name. If you also have $200,000 in debt, which may include mortgages, auto loans, personal loans, student loans, or credit card debt, the amount of your debt exceeds the value of your assets and you are insolvent. In this case, you are insolvent by $50,000, which is the difference between the amount of your debt and the value of your assets.

If you were to have $100,000 of your credit card debt or loan debt forgiven, for example, the amount forgiven is more than the amount you were insolvent. Only the first $50,000, the amount of your insolvency, gets exempted from taxation. You are responsible for taxes on the other $50,000.

Student Loan Cancellation

In the case of student loan debt cancellation, a separate set of tax rules applies. A forgiven student loan isn’t subject to taxation if it was forgiven under certain provisions. For example, you may have a student loan forgiven because you continued into a specific career field, such as teaching or nursing in in-demand areas. These special cases allow for the forgiveness of student loan debt without tax consequences.

Unfortunately, this forgiveness applies only to loans offered by the government, a school that offers programs to benefit in-demand areas, or loans from a tax-exempt public company. It is not applicable to private education loans.

If the student loan was forgiven under other circumstances, such as inability to pay or default, then the normal income taxes apply.

IRS Reporting

If a financial institution forgives $600 or more of your debt’s principal, you’re entitled to receive Form 1099-C at the end of the income tax year. This form is used to report your income. You will file your income tax return for the year in which your debt was settled as gained income.

  • If you don’t receive a copy of Form 1099-C, the creditor may still have submitted its version of the form to the IRS.
  • If you didn’t list the forgiven debt on your tax return, but the creditor submitted the forgiven debt to the IRS, you could get a bill or audit notice for your owed taxes.

The Internal Revenue Code contains several exceptions to reporting income. For example, if a financial institution issues Form 1099-C, you don’t need to report the forgiven debt as income if you were insolvent before you settled the debt.

Insolvency occurs when your debts are greater than the total value of your assets. The amount is determined by totaling your assets and debts, including forgiven debt, and determining whether your debts exceed the value of your assets. If they do, IRS Form 982 should be included with your income tax return to show insolvency.

Bankruptcy and Taxes

If you have debts discharged in bankruptcy, they won’t be taxed. This release from taxation is a significant difference between bankruptcy and debt settlement. Any debt settled outside of bankruptcy, however, is still treated as income for tax purposes.

The exclusion to debt discharged from bankruptcy is outlined in the Internal Revenue Code section 108 (a)(1)(A), which states that gross income does not include any amount which would be included in gross income by reason of the discharge of indebtedness of the taxpayer if the discharge occurs in Title 11 bankruptcy.

Depending on the state of your debt, you may want to consult with a bankruptcy attorney to determine whether bankruptcy is a better option. Although debt settlement is a valid option for many people, it may not be worth the potential tax burden you’re likely to incur.

What If I Don’t Report Forgiven Debt?

Legally, you’re required to report all taxable income received, including forgiven debt. If a copy of Form 1099-C is sent to you, the IRS will also receive the notice of income and will be able to penalize you for failing to report your forgiven debt. In this case, you’ll not only be responsible for the taxes you owe on the forgiven debt, but also the fines and penalties associated with failing to pay.

If you don’t receive a copy of Form 1099-C, the IRS won’t receive a notice of income. Still, if you’re the subject of an IRS audit for any reason, the IRS may discover your forgiven debt and realize you’ve chosen not to report it. This situation not only gives you more debt to deal with in the form of IRS debt, but it could also result in more serious legal ramifications.

Following the law and reporting all your income is always smart. While you may not want to pay the taxes you owe, especially after getting out from under a significant debt burden, it’s not worth underreporting and breaking the law in hopes that you don’t get caught.

How Can I Avoid Tax Consequences?

Paying your debt in full is the only way to avoid tax consequences. Creditors can write off canceled debts to recover their own losses. However, you may still be left with significant debt that makes it difficult for you to recover financially.

If you can’t afford the tax consequences of forgiven debt, but you’re struggling with debt that’s piling up, consider a debt consolidation loan instead. This option will still make you responsible for your entire debt, but it gives you a single monthly payment, typically with lower interest, and helps you avoid tax consequences on forgiven debt that’s considered income. Unfortunately, you may also end up with a monthly payment for a long period of time this way.

If your debts aren’t excessively high and you still have decent credit, it may be a good idea for you to apply for a no-interest balance transfer credit card. Some credit card companies offer an introductory period with no interest, usually around 18 months, which gives you time to pay off a considerable portion of your balance with a low monthly payment. This option not only removes the tax consequences, since you’re paying off the total debt, but it also helps you avoid any delinquencies or negative marks on your credit report that hurt your credit score. With this option, be sure you can pay most of the balance within your zero-interest time frame, and be sure to pay every payment on time, in full, or you may find yourself in a worse position than where you started.

Another option is to work with your creditors to set up a payment plan for smaller monthly payments. This option is usually for those experiencing financial hardship. Many collection agencies and creditors are willing to work with their borrowers, as they’d rather recover what’s owed to them than have to write it off as a loss. If you pursue this option, be sure to get the entire agreement in writing to avoid any potential problems in the future.

The tax consequences on forgiven debt are significant, so always investigate your alternatives to find out what other options exist for paying your debt, avoiding tax consequences, and protecting your credit score.

Solvable Can Help

As you can see, debt settlement may provide a clean slate and give you a new start to get your finances on track, but this act comes with a tax burden. Tax laws are complicated as well, and you may benefit from exceptions or exclusions that could save you from reporting discharged debt as income.

Before embarking on either debt settlement or bankruptcy, be sure to consider all your options and learn what to expect from the income tax liability for your forgiven debt. The last step you want to take is to go through the trouble of debt settlement or bankruptcy and find yourself buried in new tax debt, especially if you can find other suitable options.

If you need help with your debt settlement or debt relief, Solvable can provide you with financial education, verified debt companies, and access to debt relief providers that can offer immediate assistance for your debt needs. We will help you explore your debt relief options and help you get on track to a debt-free life of freedom and happiness. Contact us today to find out how we may be able to help you.


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