How to Avoid a Debt Settlement Tax Surprise

​The number of Americans struggling with high debt is increasing, according to the US Federal Reserve. Household debt in the US reached a new record this spring, the central bank said, with the average indebted household owing more than $16,000 on their credit cards.

Seeking debt forgiveness from lenders is one option to try to deal with the burden of high debt. But there is an important tax consequence: Any amount of cancelled debt is generally taxed as ordinary income.

This can come as a big surprise at tax time, when the relief of having settled a large debt is replaced by the anxiety of owing the IRS money.

Common Debt Forgiveness Surprises
Examples of when debt forgiveness can create a tax liability include:

• home foreclosures
• car repossessions
• credit card companies forgiving interest owed
• lenders agreeing to reduce or forgive credit card, medical or student loan debt
• lenders decide they can’t collect a debt, or give up trying

Will Payoulater hadn’t been making payments on a $40,000 car loan and woke up one morning to find his driveway empty. The bank had repossessed the car and cancelled the remaining $35,000 balance on his loan. However, due to depreciation and wear-and-tear, the car’s market value was only $20,000 when it was repossessed. Not only is Will down one car, he’ll also have to pay taxes on the $15,000 difference as cancelled debt income.

As you can see in this example, even the calculation of how much debt-forgiveness tax you owe can get complicated. What is the true market value of the car? Was the correct condition of the auto applied to the value? Getting some help from a tax professional can ensure you won't be overtaxed.

Some Exceptions
There are several situations where debt forgiveness is not taxable, including when:

• it happens as part of chapter 11 bankruptcy
• the debtor is insolvent (i.e. total debt exceeds the value of assets)
• student debt is forgiven as part of an agreement to work certain government and education jobs

If anyone you know is considering a debt settlement or has gone through one, please have them get in touch to work out the potential tax consequences.