In general, if your debt is canceled, forgiven, or discharged for less than the amount owed, the amount of the canceled debt is taxable. If taxable, you must report the canceled debt on your tax return for the year in which the cancellation occurred.
As credit card balances become increasingly difficult to pay down, people may turn to debt settlement for relief. If you've settled debt—with the help of a debt settlement company or on your own—you'll owe federal taxes on the amount of debt that was canceled or forgiven.
The law requires that you report all taxable canceled debt as income on your tax return, even if the amount is less than $600 and you didn't receive a Form 1099-C. Canceled debt is taxed at same rate as your ordinary income, which can be anywhere from 10% to 37% depending on your total taxable income.
Bankruptcy and insolvency
Even if you receive a Form 1099-C from a lender, you still may be able to avoid taxation on the forgiveness of a debt. If your debt was discharged in a Title 11 bankruptcy proceeding, such as a Chapter 7 or Chapter 13 case, you're not responsible for taxes on that debt.
Your income, including amounts listed on your 1099-Cs, gets taxed at the normal progressive rate, which ranges from 10% to 37%.
Once these requirements are satisfied, the principal of the loan is forgiven and, therefore, not required to be paid back to the employer. The principal of the loan is considered income to the employee and is taxable.
This can lower or even remove the tax burden on canceled debt, depending on how much you owe compared to what you own. For example, if $5,000 of your debt has been cancelled, and your total liabilities are $3,000 more than your assets, only $2,000 of the cancelled debt is taxable.
Paying off loans or debt also does not appear on tax returns. You may be able to deduct interest on the debt that you pay, but that is limited. Debt forgiveness on most loans is income that must be included on your tax return.
The most common situations when cancellation of debt income is not taxable involve: Bankruptcy: Debts discharged through bankruptcy are not considered taxable income. Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you.
Courts can issue a discharge ruling when the debtor meets the discharge requirements under Chapter 7 or Chapter 11 of federal bankruptcy law, or the ruling is based on a debt canceling. A canceling of debt happens when the lender agrees that the rest of the debt is forgiven.
The compensation you receive that is directly related to your physical injury is not typically taxable in the state. Even settlements related to emotional distress may not be taxable if the emotional distress is related to a physical injury. However, if punitive damages are awarded, those are taxable in California.
Debt discharge is the cancellation of a debt due to bankruptcy. When a debt is discharged, the debtor is no longer liable for the debt and the lender is no longer allowed to make attempts to collect the debt. Debt discharge can result in taxable income to the debtor unless certain IRS conditions are met.
You will receive a 1099-C Cancelation of Debt form if a lender forgives more than $600 of taxable debt. You must include the amount of canceled debt on your federal tax return as a part of your taxable income.
There are four main forgiveness programs accessible to taxpayers: Installment agreement — The most common repayment period is 72 months. The IRS recommends this if you can't pay your tax debt in full, including penalties and interest. Offer in compromise (OIC) — You offer to pay the IRS a fraction of what you owe.
One of the key strategies to minimize or avoid paying taxes on forgiven debt is by proving insolvency. If you're insolvent at the time of the debt settlement, you may qualify to exclude the forgiven amount from your taxable income.
The IRS Has The Final Say
If you receive a settlement in California that is considered taxable income, you will need to report it on your tax return. You will typically receive a Form 1099-MISC, which reports the amount of taxable income you received during the year.
You may be able to defer tax on all or part of a lump-sum distribution by requesting the payer to directly roll over the taxable portion into an individual retirement arrangement (IRA) or to an eligible retirement plan.
Canceled debt is taxed at the same rate as ordinary income. As a taxpayer, your tax rate depends on your tax bracket and can range from 10% to 37% depending on your taxable income. For example, if you're in the 15% tax bracket and had $10,000 of debt discharged, you may owe income taxes up to $1,500.
To establish your right to exclude the money shown on the 1099, you have to file IRS form 982. If you don't file the form and claim the exception, the IRS has no way to know that, despite the debt forgiveness, there is no tax payable.
Sometimes, even when debt has been forgiven, the lender may not have reported it to the credit-reporting bureaus. The debt may have even been sold to a debt collector. If this happens the creditor may have no legal right to collect once the debt has been forgiven and a Schedule 1099-C issued.
A creditor will report the amount you didn't pay because of a debt settlement to the IRS. Unless an exception or exclusion applies, the IRS will consider the canceled debt as taxable income to you. Of course, the IRS wants to collect tax on this money.
In addition, section 108(a)(1)(B) of the Code provides that a taxpayer may exclude from gross income a discharge of indebtedness that occurs when the taxpayer is insolvent (the insolvency exclusion).
According to the IRS, student loan amounts forgiven under PSLF are not considered income for tax purposes. Learn more about the PSLF process. You won't be taxed by the federal government, but your state may tax you. Any debt forgiven as a result of PSLF won't create a federal tax liability for you.