Thursday, August 11, 2022

Is Forgiven Credit Card Debt Taxable

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How Does Cancellation Of Debt Affect Your Taxes

1099 C Cancellation of Debt – Understanding Tax on Forgiven Debts

In many cases, canceled debt may add to your taxable income. This can increase how much you owe the IRS or eat into your expected tax refund. Heres an example:

  • You made $40,000 this year, and due to higher-than-necessary withholdings on your paycheck, youre expecting a $1,000 refund.
  • You also settled debts for $15,000 this year. That means the IRS might consider you having $15,000 more in incomebringing you up to $55,000.
  • You didnt yet pay taxes on that $15,000, so you may need to do so in April. Depending on all other factors, that tax amount could take your entire $1,000 refund, and you could owe even more.

Not all canceled debt works against you when it comes to tax burdens, though. The IRS provides a list of exceptions of 1099-C canceled debt that isnt added to income. That includes:

As you can see, whether or not a canceled debt is counted as income for federal tax purposes can be a complex topic. The bottom line is that discharged debt may come back to burden you in the form of additional income on your tax return, so its important to be aware of this possibility.

Who Files A 1099

A lender files a 1099-C with the IRS and theyll send you a copy of the form. While you dont have to file the 1099-C, you should use it to prepare and file your income tax return.

In some cases, your forgiven debt is taxable and in some its not.

When it is taxable nonbusiness debt, youll use the copy of the 1099-C to use to report it on Schedule 1 of Form 1040 as other income. But there are exceptions to paying taxes on your cancellation of debt, which well outline below.

When Youre Struggling To Pay Your Bills Having Debt Forgiven Can Seem Like A Light At The End Of A Long Dark Tunnel But Your Canceled Debt May Still Cost You In The Form Of Federal Income Tax

When the lender walks out the door and closes it behind him, the tax man knocks, says Riley Adams, a CPA from financial blog Young and the Invested.

Thats because the IRS generally treats forgiven and canceled debts like income. For example, if you settle with your credit card company for $5,000 less than you owe, the IRS views it the same as if your credit card company cut you a check for $5,000.

But all hope isnt lost the tax code has a number of exceptions and exclusions to this rule. And even if you do end up owing, you may be able to apply for an IRS payment plan so that you can pay off your tax debt over time.

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Who Can File Form 1099

There are three copies of the 1099-C. The lender must file Copy A with the IRS, send you Copy B, and retain Copy C.

If you borrowed money from a commercial lender and at least $600 of that debt was canceled or forgiven, you should receive Form 1099-C from the lender. The issuer also sends a copy of the form to the IRS. For example, assume you borrow $10,000 and default on the loan after repaying $4,000. If the lender cant collect the remaining debt from you, they may cancel the debt, which means the remaining $6,000 is reported on Form 1099-C. This amount is generally considered taxable income.

The left side of the form includes details about the creditor and the borrower , including names, addresses, tax identification numbers, and the associated account number. The right side of the form has seven boxes:

Canceled debt counts as income in most cases, which means it must be reported to the IRS.

How Much Tax Do You Have To Pay

Is Debt Forgiveness Taxable?

Paying the tax is still better than paying the entire balance.

For example, if youre in the 15% tax bracket, an additional $1,000 in taxable income will cost you around $150.

The IRS will tack on interest expense, but fortunately, the interest rates for individuals are relatively low.

Have you ever been surprised to receive a notice of cancellation of debt from a long-forgotten debt or a debt you didnt know you owed?

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What If My Debt Is Forgiven

The tax impact of debt forgiveness or cancellation depends on your individual facts and circumstances. Generally, if you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt. There are several exceptions to the taxability of cancelled debt, such as insolvency or bankruptcy.

Mortgage Forgiveness Debt Relief Act

Due to the magnitude of the real estate market collapse that began in 2007, Congress passed the Mortgage Forgiveness Debt Relief Act in 2007. For calendar years 2007 through 2020, you can exclude up to $2 million in forgiven mortgage debt if you were married and filing jointlyup to $1 million for other filing statuses. This also applies to debt that was discharged in 2021 provided that there was a written agreement entered into in 2020. This exclusion also applies to mortgage debt forgiven through a mortgage restructuring or in connection with a foreclosure.

The Consolidated Appropriations Act was signed into law on December 27, 2020 as a stimulus measure to provide relief to those affected by the pandemic. The CAA extends the exclusion of cancelled qualified mortgage debt from income for tax years 2021 through 2025. However, the maximum amount of excluded forgiven debt is limited to $750,000.

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Hiring A Debt Settlement Company

All in all, the decision to hire a debt settlement company boils down to the following factors:

Advantages:

  • A debt settlement company is likely to know which creditors are more inclined to settle and for how much.
  • A debt settlement program will provide you with the discipline to save money every month that you can use as leverage when negotiating. Remember that no creditor will want to make a deal with you unless you are ready to make a lump-sum payment.

Disadvantages:

  • Hiring a debt settlement company will cost you a lot of money.
  • Many debt settlement companies are known to be scams and do not have your best interests at heart.

If you do ultimately decide to hire a debt settlement company, this is roughly how things will work. Once accepted into a debt settlement program, consumers generally make payments to both the debt settlement agency and into an independently managed savings account. The payments to the debt settlement agency covers their fees and are typically non-refundable. The money from the independently managed savings account is leveraged by the debt settlement agency to negotiate with your creditors and should remain liquid and refundable in case you decide to withdraw from the settlement program.

Fees:

Debt settlement companies may not assess fees until they have:

Disclosures:

Before a consumer enrolls in a debt settlement program, the settlement company must notify them about:

Filing An Exclusion For Principal Residence Indebtedness

What Is Tax Debt Forgiveness

The second most common canceled debt exclusion is for qualified principal residence indebtedness. A qualified principal residence is your primary home that you live in most of the time. This type of cancellation most commonly happens when the lender agrees to a short sale or starts a foreclosure action.

Until 2016, IRS allowed an exclusion of up to $2,000,000 in canceled mortgage debt arising from foreclosure or short sales of taxpayers principal residences. This exclusion allowed the vast majority of taxpayers forced into foreclosure or short sales to escape the double penalty of a tax bill for any unpaid mortgage debt.

However, beginning in 2017 the IRS dialed back the exclusion. Now, the IRS now only allows the exclusion if the discharge was subject to an arrangement that was entered into and evidence in writing before January 1, 2018 . So, while this provision has provided immeasurable relief over the past 10 years, it may not exist much longer.

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Filing It With Your Taxes

Now, once you have figured out whether you need to claim the income or not, you must incorporate the 1099-C into your federal tax returns. That income will be added with your other forms of income to determine how much you tax liability is for the yeari.e. how much you owe. Unfortunately, that could result in a reduction of your tax refund, or worse, it could mean that you owe the IRS money. And if you dont pay it off immediately, it will turn into back taxes.

Filing An Exclusion For The Cancellation Of Debt Due To Insolvency

Applying for the insolvency exclusion involves filling out a form detailing all the taxpayers liabilities and assets . The IRS allows taxpayers to exclude canceled debt in an amount equal to how much their liabilities exceeded their assets.

For example, if a taxpayer has $10,000 in liabilities and $7,000 in assets, that taxpayer can exclude the difference they qualify for forgiveness for up to $3,000 in canceled debt. The tax on $3,000 could up to almost $1,200. So, claiming this exclusion can make a big difference on the tax returns bottom line.

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Planning For The Tax Consequences Of Debt Settlement

Generally, if your lender is willing to negotiate with you on a debt settlement, you should do it even if there are tax consequences. Thatâs because the amount you end up paying in taxes will be less than that of the amount of debt your lender forgives. Still, itâs good to be mindful that your tax bill may be higher. Preparing for a higher tax bill is just smart tax planning. You can try to put some money aside to cover the additional tax penalty.

Or, if possible you can pay these taxes before filing your annual tax return to the IRS. This can help you avoid an underpayment penalty. Most taxpayers either have their employer withhold taxes from their paycheck or make quarterly estimated tax payments to the IRS. But if you have more taxable income in a given year because a lender forgives a debt and you havenât accounted for it in your withheld taxes or quarterly payments, you may face an underpayment penalty.

Rather than dealing with an underpayment penalty or having to pay the estimated income tax payments when you file your annual tax returns, you could just make a payment to the IRS on its website or ask your employer to adjust your tax withholdings from your regular paycheck. Some taxpayers routinely adjust their tax withholdings throughout the tax year because their income fluctuates seasonally.

If It’s Taxable Be Prepared

Bankruptcy and Insolvency Exception to IRS Rule That Debt Forgiveness ...

If you’ve taken advantage of a debt forgiveness program, the sooner you find out about the tax implications, the better. Speak with a tax professional to find out whether you qualify for an exception. If you do, you don’t need to do anything else.

If you don’t, however, you may need to start preparing for the tax bill. A tax professional can help you run the numbers based on how much you currently have withheld from your paychecks and which deductions and credits you qualify for.

If you end up owing money, start working on a savings plan now to ensure you can afford to pay it. While the IRS offers installment plans for people who can’t afford to pay by the due date, they charge interest and a penalty until you pay in full.

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Why Am I Getting A 1099

Unfortunately, creditors have a lot of wiggle room about when to report canceled income to the IRS. Statutes of limitations vary by state and by type of debt, but creditors are not required to file a 1099-C at that time since they can continue to try to collect on debt indefinitely.

Consumer advocates argue that under IRS guidelines, creditors should send a 1099-C three years after there has been no activity on the debt, but they acknowledge the rules are unclear. And plenty of taxpayers have been getting 1099-Cs for debt thats many years or even decades old.

If this happens to you, first try calling the creditor.

Sometimes when you go to the creditor, it turns out it was a mistake and they will issue an amended one, said Greg Fitzgerald, an attorney who specializes in debt.

If thats not the case, you will need to include the 1099-C on your tax return. A tax professional can then help you evaluate your options.

You can either try to explain to the IRS why it should have been filed a long time ago and make that case as part of your tax return. Or it may be easier to simply use one of the exemptions to avoid paying the amount.

However, the age of the debt can work against taxpayers, said Gary Bode, CPA. The time of financial hardship that caused the debt to go unpaid may have passed, leaving the taxpayer with a reduced ability to exclude the debt from income because of insolvency.

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What Does It Mean When A Debt Is Canceled

Debt is considered canceled when its forgiven or discharged even though you didnt pay it back as agreed. Here are a few examples of times when a debt is considered canceled.

  • You owe a credit card company $10,000 and are behind on payments. The credit card company has filed a lawsuit or otherwise notified you about the collections activity. You negotiate, agreeing to pay $6,000 to have the debt considered paid in full. The credit card company agrees to this settlement, which means $4,000 of your debt has been canceled.
  • You buy a car for $30,000 and make a total of $10,000 in payments. You can no longer afford the payments and fall behind on payments. The bank repossesses the car, but you still owe $20,000 on it. If the car is worth $15,000, the bank can sell it and recover that much of the loanleaving $5,000 of debt to be canceled.
  • You file for bankruptcy with $60,000 in unsecured debts, which are all discharged. That debt is also considered canceled.

Not all debts that are canceled require a 1099-C. They also dont all impact your taxes. If you had any debts canceled or expect to receive a 1099-C, you may want to work with a professional tax service to file your 2020 taxes.

Exception : Business Farm Exclusions

Tax Consequences of Forgiven Debt (debt settlement)

You may not have to pay tax on canceled debt if it was in connection with your farm or if the debts were attached to business real estate and were forgiven when you owed more than the property was worth.

See Cancellation of Debt in IRS Publication 225, Farmers Tax Guide or Business Income in IRS Publication 334, Tax Guide for Small Business for more information.

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How Does Debt Settlement Work

Overview:

First of all, its important to note that credit card debt settlement is only a viable option if you have already defaulted on what you owe or are close to doing so . In other words, you have to be around 180 days behind on your credit card payments to even qualify for consideration.

With that said, there are two basic types of debt settlement: 1) do it yourself debt settlement and 2) service-assisted debt settlement. You can also attempt to settle the following types of debt:

  • Unpaid medical bills
  • Unpaid phone bills

The fundamentals, however, are the same regardless of which type of debt settlement program you choose or what type of debt youre trying to settle. Basically, the debtor approaches the creditor with a partial payment offer and asks that the remaining amount be forgiven. The creditor can then accept, reject, or counter this offer.

Once both parties agree on a settlement amount, the party that owes the money will be required to submit the respective lump-sum payment within a specified timeframe. Doing so will satisfy and officially close the account in question. Not doing so will likely increase the odds of the creditor suing for the full amount owed.

Tax & Credit Score Implications:

How Your Creditors Will React:

If you are trying to settle debt that you have already defaulted on and are not making payments towards, then your creditors will continue to contact you as often as they did prior to entering the debt settlement program.

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