Can you eliminate debt by settling with a creditor to pay less than you owed and still come out on the short end? It is possible, based on potential tax liabilities.
Let’s assume you settled a credit card debt for $2,000 less than you owed. From the perspective of the IRS, that is no different from if someone gave you $2,000 or you earned $2,000 to pay off that debt. Even though you did not earn it, in most cases that debt forgiveness must be included in your taxable income for the year in which it was forgiven (entered as “other income” in your tax form).
The tax bill kicks in when the forgiven debt principal is over $600 (excluding interest and any applicable fees). In that case, the creditor is generally required to fill out a 1099-C form with the IRS and send you one as well. While creditors are obligated to let you know about this potential tax issue, they are not obligated to make sure you receive any notification letter (just that they sent one) — and they certainly are not required to verify that you pay attention to the notification and understand the consequences.
Many people throw the notification away, assuming it is a mistake since the debt was forgiven, or that the notification is a scam. Never throw an IRS-1099 form away, because you were sent it for a reason. Even if that reason is wrong, you need to clear the situation up with the IRS before filing to avoid penalties.
If the forgiving creditor fails to send you a 1099-C form, that does not remove your obligations to report the cancelled debt as income. However, if you did not receive a form, there may be an underlying reason why. Double-check with the creditor, because it is possible your debt never really was cancelled.
When you receive a 1099-C form, is it a given that you have to include the debt as taxable income? Not entirely. There are exceptions and exclusions to this rule, most notably the Mortgage Forgiveness Debt Relief Act that was passed to help underwater homeowners (those owing more than their houses were worth). Few, if any, homeowners in that situation could afford to pay the resulting taxes since they were either selling at a loss or potentially losing their home outright.
The difference between an exception and an exclusion is that exclusions also include the need to reduce the tax basis of an asset. Start by looking through the exceptions; if nothing there applies to your case, then consider the exclusions. Exceptions include gifts or inheritances and cancellations of certain types of student loan. Exclusions include Title 11 bankruptcy or insolvency and qualified farm indebtedness.
If you are not sure whether your debt can be excepted or excluded, start by referring to IRS Tax Topic 431, “Canceled Debt – Is it Taxable or Not?” which can be found on the IRS website at http://www.irs.gov/taxtopics/tc431.html. This page lists the general categories and provides links to other relevant IRS pages based on the nature of your forgiven debt. Another useful resource is IRS Publication 4681, “Canceled Debts, Foreclosures, Repossessions, and Abandonments”, available at http://www.irs.gov/pub/irs-pdf/p4681.pdf.
Need more help? Contact your local IRS office or seek the advice of a tax professional who is familiar with debt cancellation rules. Theoretically, through extra taxes and penalties, you could end up paying more than the debt that was cancelled, thus winning the battle but losing the war. Remember: it is rare to win even a battle with the IRS, much less a war.