Right at the outset, you must know that when you want to settle your debt directly with your creditors or through a debt settlement company, you are liable to pay tax on the amount reduced. However, debt consolidation loans and debt management plans can be exceptionally helpful when you use it properly. This is ideally the last straw for people struggling with their money troubles. It will help you to regain your financial health slowly but surely and get it back on track ensuring financial wellness.

When a loan amount is reduced through debt settlement, it is called forgiven debt and is an income for the borrower. As per the law, all incomes are taxable and so are the amounts waived on your loans.

However, there are a few exceptions to the rule. When the government understands that you are unable to make any payment and have declared bankruptcy, you may be exempted for paying taxes.

Reporting Forgiven Debt

To know and track the amount forgiven by your creditor, the IRS has specific guidelines that you and your creditor need to follow. You can come to know about these guidelines following the debt settlement reviews or visiting the official website of IRS. According to this rule, the creditor must issue you a1099-C form.

This form is issued in January and mentions the amount that was unpaid and forgiven in the preceding year. This amount must be in excess of $600.

  • A copy of the 1099-C form is also sent to the Internal Revenue Service and also to the tax collection of your state or locality.
  • This does not mean that in case any such form is not sent to you by the creditor for any reason you are exempt from paying taxes on your reduced debt amount. You must report it in your income tax return.

However, the tax amount that you will pay will be significantly less than the amount that is waived from your debt. Therefore, such legal obligations are still considered favorable.

A Few Exceptions

There are a few exceptions to the tax consequences rule of debt settlement and forgiven amount such as:

  • When the forgiven debt amount is of a mortgage, the tax liability is exempted.
  • If you are proved insolvent and
  • If you file for bankruptcy.

Forgiven Mortgage Amount

There are a few specific points to know about mortgage exemption as far as tax consequences are concerned.

  • The mortgage aspect covers all aspects of it including any building or improving the primary residence.
  • On the other hand, if the settled debt was not used for any purpose of your primary residence, it is will be considered as your income and therefore will be taxable.
  • As per the rule, this exemption is allowed on for the first $2 million of the debt qualified. If the amount is higher than this specified limit usual income tax is applicable.
  • The $2 million cutoff is applicable to both individuals as well as married couples.

However, everything must be mentioned in your tax report irrespective of the fact that you receive a 1099-C form or not.

The Insolvency Aspect

According to the government rules, you are declared insolvent when you are unable to pay off your debts. Such situations arise when the amount of your total debt exceeds the amount of your total assets including income. If you are insolvent, then the tax will be exempted if your debt amount is forgiven.

However, there is a catch here as well. The income taxation will be exempted only up to the amount of your insolvency. For example, assume that your assets including car, home, retirement benefits, investments amounts to $100,000. On the other hand, you have a total debt of $120,000 in the form of auto loans, mortgage, credit card and student loans. In such a case you will be declared insolvent as your debts exceed your assets by $20,000.

Further, if credit card debt of $30,000 is forgiven this will be an amount that is greater than the amount of your insolvency. In this case, only the first $20,000 will be exempted from taxation, and the remaining $10,000 will be taxable.

In Case Of Bankruptcy

In case of bankruptcy, nothing is taxable when your creditors forgive debt amount. This is a specific case and situation that is entirely different from insolvency and home loans.

The government has no limit on forgiven debt amount in case you are declared bankrupt, and therefore you are liable to pay tax on any amount forgiven. Read the debt settlement reviews to know more about bankruptcy.

Student Loan Cancellation

There is an entirely separate set of income taxation rule for canceled student loans. In general, a student loan when forgiven is not taxable, but that has to be within the provisions of the loan. For example, if you go for a particular teaching or nursing profession in underserved areas then the money forgiven will not be a taxable income.

However, this is applicable only to those loans provided by the government, a school with such programs and a tax-exempted public company. This rule is not applicable for any private education loans.

For any other circumstances such as the inability to pay the loan back, you will be charged under normal income tax rules if your debt amount is forgiven.

New Ramifications To The Rule

There are a few specific corollaries to the tax exemption rule for forgiven debt amount. These corrections include homeowners hit by foreclosure, or any short sale provided it is filed with an amended return.

  • The new rule also exempts unpaid student loan debts due to disability or death.
  • To reduce the work pressure and burden on the taxpayers, the rule has also reduced the issuance of 1099-C forms for debts that have 36 months of non-payment.

Most importantly, the current law does not make it mandatory for a debt buyer to disclose a settlement of debt through a 1099-C form. This is due to the confusion in the communication that is inadequate to the Congress.

Author Bio:

Amy Walsh is an experienced and skilled business consultant and Financial advisor. She helps clients both personal and professional in long-term wealth building plans. During her spare time she loves to write on Business, Finance, Marketing, Social Media. she loves to share his knowledge and Experts tips with her readers.