You've gone through the ordeal and sometimes incredibly long process of settling your debt. Whew, glad that's over. Now on to rebuilding your finances, right? Not quite, when you go through a debt settlement there are tax consequences.
Surprise, Surprise! You Now Have to Report Phantom Income
Many consumers are surprised that the IRS and their state government considers debt forgiven as income.
When a debtor forgives any amount of what you owe, the IRS and your state government will see it as income to you. That means that amount forgiven is taxable income, and you will have to pay taxes on it. For example, let's say that you owe $15,000 to a credit card company but you were able to successfully negotiate with them and they settle the debt of what you owe at a lower amount - $11,000. You pay $11,000 to the credit card company, which then forgives the debt and reports it paid in full. That's the end of it right? Not yet, the credit card company by law has to report the settlement to the IRS. Which then causes the IRS to notify you that you must pay taxes on $4,000, the amount the credit card company forgave. To see another blog post on debt settlement check out the dangers of DIY debt settlement here. Know this: The IRS considers the settlement as though the credit card company gave you $4,000. Your debt collector will then send you a 1099-C Form (Cancellation of Debt).
What is a 1099-C Form?
The 1099-C Form (Cancellation of Debt) is the form you must use to report each debtor that canceled $600 or more debt owed by you as "income" on your federal income tax return. Surprise! Many consumers have no idea what the 1099-C Forms are. Don't make these mistakes:
- Trashing the cancellation of debt notices because they are sent by your previous debt collectors. -OR-
- Completely ignoring and not filing the 1099-C Forms with your federal income tax return.
Take-away: Not filing the 1099-C Forms put you at risk for an IRS audit, possible penalties and fines.