Forgiven debt is a good thing, but it can yield a tax bill

The debt consolidation industry thrives on people with debt; they want you to believe that only they can get you out of your financial hole. That’s not true, of course, you are just as capable, if not more so, than they are of fixing your financial problems. You even have an added advantage in that you aren’t trying to extract some profit out of yourself like the debt consolidation companies are. You just want to pay less money.

As we have pointed out before, creditors are usually agreeable to negotiating with customers who have unpaid debts. The creditors would rather have some money than none at all, and if you are seriously delinquent, they may be willing to agree to settle for less than the total amount that you owe them. That’s great from your standpoint. But you need to be aware that there are several things to consider if you get your creditors to agree to settle for less. The most significant of these is the fact that the forgiven debt will be treated by the Internal Revenue Service as taxable income.

Income? Yes. The IRS regards the amount of forgiven debt as essentially a cash gift. If you owed $10,000 and your creditor has agreed to accept $5000 to settle, the IRS considers that you have “earned” $5000. And as this is regarded as earned money, you will be expected to pay income taxes on it. If you are in the typical 28% tax bracket, you could expect to pay some $1400 in taxes on the $5000 non-debt. This could come as quite a shock to you, especially since, unlike other income, you haven’t had any withholding taxes taken out of this sum.

Your creditor will send you a form 1099, which is a form that employers use to report income to contract personnel. A copy of this will be sent to the IRS, so there is no hiding it from them. They know that you earned this money, and they will expect their taxes. From a debtor’s standpoint, this is sort of a mixed bag; you have replaced one debt with a somewhat smaller one. The downside is that the IRS will want their money, in full, on April 15.

You should be aware that there are some other ramifications of having debt forgiven in addition to the added tax burden. If your creditor agrees to accept a lesser amount, this will be recorded on your credit report as “paid as agreed.” This is sort of a black mark; you would much rather have a comment that says, “Paid in full.” Future lenders and creditors will note that this indicates that you had a portion of an unpaid debt forgiven by a lender.

If you cannot pay your debts, negotiating you way to a lesser payment is a sound strategy. Just be aware that you cannot get something for nothing. If your creditor agrees to take less money, you will have to pay taxes on the difference.

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