Why is debt settlement considered income?
After you settle a debt of $600 or more, your former creditor — or a debt collector — is likely to send you a form 1099-C the January after your settlement closes. The 1099-C tax form reports the amount of debt it cancelled or forgave. You're required to report it as other income.
Settled debt is taxed as ordinary income. The amount you'll pay is based on your tax bracket and marginal tax rate. Say you earn $75,000 a year as a single taxpayer. Your top marginal tax rate is 22%, so any additional income from a settled debt will be taxed at 22%.
With certain exceptions, any debt you manage to have discharged or canceled by a creditor is considered taxable income under federal law. That means you must report it when you file your tax return for the year and pay taxes on it—even though you didn't receive any actual money.
Generally, if you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
In many cases, that canceled debt is considered taxable income. If the amount of the canceled debt is $600 or more, the creditor should send you a Form 1099-C, Cancellation of Debt before you file your taxes for the year. 1 The information on this form is also reported to the Internal Revenue Service.
You should expect to pay the same income tax rate for settled debt as you pay on your income. For example, if you're in the 22% income tax bracket and have $600 worth of canceled debt, the tax bill would come out to $132 ($600 x 0.22).
- Allocate Damages Appropriately. ...
- Spread Payments Over Time. ...
- Consider Qualified Settlement Funds. ...
- Take Advantage of Capital Gains Treatment. ...
- Seek Professional Tax Advice. ...
- Eliminate the Taxation of Attorney Fee Portion.
Depending on the rest of your financial status, when you have a settled debt for less than the full amount owed, you may owe taxes on the money that was forgiven. The IRS considers any debt cancelation of $600 or more as additional income — and taxable — even if you didn't actually receive any money.
Debt settlement is a risky way to reduce your debts. It will help you avoid bankruptcy, but depending on the settlement amount, you may be stuck paying extra taxes. Many debt settlement companies charge high fees and take years to negotiate your debts fully.
Your forgiven debt includes tax-deductible interest.
If a lender forgives a business loan or mortgage, you don't need to report the interest as income because it would have been deductible anyway. But you will still be on the hook for the canceled principal amount of the loan.
Is debt relief included in gross income?
Unless an exception or exclusion applies, debt that is discharged, forgiven, or cancelled by the lender must be included in the borrower's gross income. The amount of income reported from debt cancellation is generally the difference between outstanding debt owed and any amount paid to settle the obligation.
“Black hole” CODI: If the debtor consolidated group's CODI exceeds the amount of attributes of the group, this excess CODI generally is referred to as “black hole CODI.” Black hole CODI generally means that the taxpayer can exclude the CODI from taxable income without any corresponding reduction in attributes.
Debt forgiveness may negatively affect credit scores, making it challenging to obtain future loans or credit. Forgiven debt of more than $600 may be considered taxable income, potentially resulting in a hefty tax bill.
Settlement money and damages collected from a lawsuit are considered income, which means the IRS will generally consider that money taxable.
| Pros | Cons |
|---|---|
| Might be able to settle for less than what you owe | Creditors might not be willing to negotiate |
| Pay off debt sooner | Could come with fees |
| Stop calls from collection agencies | Could hurt your credit |
| Could help you avoid bankruptcy | Debt written off might be taxable |
Legal settlements that are taxable (including previously deducted medical expenses related to physical injury or illness) are entered as miscellaneous (other) income. Interest earned on settlements is taxable income and should be entered as a Form 1099-INT.
If you can afford to pay off a debt, it is generally a much better solution than settling because your credit score will improve, not decline. A better credit score can lead to more opportunities to get loans with better rates.
There is a high probability that you will be affected for a couple of months or even years after settling your debts. However, a debt settlement does not mean that your life needs to stop. You can begin rebuilding your credit score little by little. Your credit score will usually take between 6-24 months to improve.
In most situations, if you receive a Form 1099-C from a lender, you'll have to report the amount of cancelled debt on your tax return as taxable income. Certain exceptions do apply.
According to the IRS, your taxable income does not include the following: Settlement money you receive from claims involving unspecified physical injuries. Benefit payments you receive from your employer's workers' compensation insurance. Money you get through your health insurance for covered medical expenses.
What percentage of a settlement is taxed?
Taxability of Personal Injury Settlements in California
The tax rate is based on the highest marginal tax rate in the state, which is currently 13.3%. There are some exceptions to this general rule. For example, if you settle a workers compensation claim, the settlement is not subject to taxation.
Even if you didn't receive a Form 1099-C, you must report canceled debt as gross income on your tax return unless one of the exceptions or exclusions described later applies. Amount of canceled debt. The amount in box 2 of Form 1099-C may represent some or all of the debt that has been canceled.
If you owe back taxes, the IRS can even take your settlement check to offset unpaid taxes. We'll discuss different types of legal settlements and what you need to know about how the IRS taxes settlement payments.
Settling debt can have both a negative and a positive effect on your credit scores. You're most likely to see a drop in points up-front, but over time you can gain back everything you lost and more. Regardless of the setback, you can always work to experience the benefits of better credit.
Tax Implications: Settlement payments are generally taxable unless they fall under specific exceptions. In this case, the settlement amount received from DoubleDown Interactive may be considered taxable income.
