You might get hit with taxes on forgiven debt
If you settle your credit card debt for less than what you owe, you might be hopeful for a future with a fresh start.
But first, you'll have to deal with the IRS.
Settlement of credit card debt is an example of debt forgiveness that comes with tax implications.
Consider this example:
Andrew rings up $100,000 in credit card debt over a few years. Andrew calls his credit card company and offers $70,000 cash to settle the entire debt. The credit card company accepts the deal. Andrew pays $70,000 cash and the rest of the debt ($30,000) is forgiven.
Although Andrew might think he just scored a great deal, the credit card company must report the $30,000 of debt forgiveness to the IRS. And the IRS will view that $30,000 as income to Andrew.
This unexpected income is treated for tax purposes just like Andrew’s salary. Along with his W-2 and other 1099s, Andrew will receive a 1099-C that reports the amount of the canceled debt.
This is what tax professionals call "dry income" -- Andrew has income but no cash. If Andrew’s effective tax rate is 30%, he’ll end up paying $9,000 of income tax on $30,000 of forgiven debt.
Fortunately, there are some IRS exemptions to this general rule and three in particular that could apply to many taxpayers:
- Bankruptcy: If the debt is forgiven or discharged in bankruptcy, none of the forgiven debt is income.
- Insolvency: If the debt is forgiven when the taxpayer is insolvent, some or all of the forgiven debt may not be income. A taxpayer is insolvent when the fair market value of his or her assets is less than the total amount of debt owed to all creditors.
- Residence: If your mortgage or home equity line is forgiven because of foreclosure or short sale for a principal residence, and is forgiven prior to Jan. 1, 2013, the forgiven debt may not be income. The temporary tax break was enacted as a result of the foreclosure crisis. Mortgage debt forgiven in a vacation or second home would not be exempt.
Before settling debts for less than the full amount, consider the possible tax effects, including whether you can pay the tax that will be due or whether you fit into one of the exemptions.
Clint Costa is an attorney and CPA at the law firm of Shaheen, Novoselsky, Staat & Filipowski in Chicago.