Credit card debt settlement can leave you owing taxes on the forgiven balance.

If you’re in debt and have only one or two credit cards that you need to clear up, you may want to look into settling your debt.

It’s no secret that lots of debt buyers and collectors will negotiate to reduce the balance due and let you pay it off all at once.

After all, it makes sense for them to settle. Most companies buy past-due debt for a fraction of the face value, so when you settle they still make a profit.

You may think you’re getting away with paying less by engaging in credit card debt settlement. Sometimes you’re right.

But without proper planning and guidance, you may find yourself in a bad situation.

Credit Card Debt Settlement Makes For Taxable Income

When you settle a credit card debt, the lender or debt buyer may be required to file Form 1099-C, Cancellation of Debt.  This form must be filed if the creditor has canceled $600 or more of a debt you owe.

Because you no longer have to pay the debt in full, the IRS treats the forgiven amount as income.

You may need to pay taxes on that forgiven amount.

Avoid Paying Taxes On The Forgiven Debt

There are two circumstances under which you may not need to pay taxes on the amount that’s wiped out in a credit card debt settlement.

Under Internal Revenue Code Section 108(a), you do not need to include the forgiven amount of the credit card debt in your gross income if the discharge occurs in a bankruptcy case or the discharge occurs when you are insolvent.

In order to waive the tax liability, you’ll need to file IRS Form 982.

The Insolvency Test

If the settlement occurred while you were insolvent, you won’t need to pay taxes on the amount forgiven.

You are considered insolvent if your liabilities exceeded the fair market value of your assets when the debt was settled.

According to the IRS, liabilities include the following:

  • the entire amount of recourse debts;
  • the amount of nonrecourse debt that is not in excess of the fair market value of the property that is security for the debt; and
  • the amount of nonrecourse debt that in excess of the fair market value of the property subject to the nonrecourse debt to the extent nonrecourse debt in excess of the fair market value of the property subject to the debt is forgiven.

I’m a lawyer who’s been working in this field for well over 15 years, and that makes my head spin a bit every time I read it.

There’s a worksheet in IRS Publication 4681, but it’s a better idea to work with a tax professional who understands debt cancellation issues to make sure you don’t botch the job.

In The Right Hands, This Could Work Out Just Fine

When someone calls me to settle a credit card debt, the first thing I do is run through their financial situation to see how the tax implications stack up. Then we talk about possible credit card debt settlement options – how they’ll pay any tax debt, how to balance the settlement with any amounts due, and the like.

It’s the smartest way to approach the problem, knowing in advance what you’re up against rather than scrambling at the end of the tax year. I recommend that you find a lawyer or tax professional who works this way, or in a similar vein.

Because it’s a real downer to settle a credit card debt only to find out later than you’re not done paying the piper.