Debt Settlement Can Increase Your Income – And the Amount of Income Tax You Owe

With more people struggling to pay their debts, there is an increase in the number of people who are looking to “settle” their debts with their creditors. A debt settlement is a process in which an individual, or a company acting on behalf of the individual, contacts their creditors to request a settlement amount that is less than the total balance owed. It is not unheard of for a successful debt settlement negotiation to result in the individual paying less than half of the total amount owed to fully repay their obligation to the creditor.

For example, if you owe $5,000 on a credit card, negotiating with the creditor may result in you being able to pay a lesser amount – say $2,100 – in exchange for the creditor closing the account and marking it as “paid” or “settled” on your credit report. You no longer have any obligation to the creditor for that particular account.

Creditors are finding that settling debts may be a better option in these difficult financial times than waiting as more people are defaulting on their debts or filing bankruptcy. So, while the creditor receives less than they would if the individual continued to make payments on the account, a settlement is often a better arrangement for the creditor than when someone files bankruptcy because they can't keep up with their payments.

Potential Disadvantages of Saving Money with a Debt Settlement

How can saving money in difficult financial times be a disadvantage? Well, as they say – nothing in life is “free” and if it seems too good to be true, it often is. Debt settlements may reduce the amount you have to pay, but they're not always worth throwing a celebration party over! The creditors who agree to settle your debts are required to send you and the IRS a form 1099-C which indicates how much money you saved. So if you paid $2,100 on the $5,000 you owed to settle the account, you saved $2,900. Any money saved that is greater than $600 must be reported on your tax return as income, unless you meet the criteria for the “exception” to this rule.



The IRS has an exclusion for the reporting of the amount of money you save through settling accounts as income if the individual was insolvent at the time the account was settled. Insolvent means that a person is unable to pay their debts – which is most likely anyone who considers and gets approved for a settlement. It means you have a negative net worth and owe more than you have in assets. So the majority of individuals would fall under this insolvency rule, which is described fully in IRS Publication 908 (in the “Bankruptcy Tax Guide”). You don't need to declare bankruptcy to take advantage of the insolvency rule, either.

If you do end up having to pay taxes on canceled balances (over $600), you've still saved a lot of money on what you owe (and the interest they would have accumulated, not to mention potential late fees) that makes having to pay a little more at tax time a better deal than struggling with excessive credit card debt. Typically people who have a lot of equity in your home or other property that is worth more than what your debts are, your networth will be positive and you would end up having to pay tax on the amount you save during a debt settlement. With most people having upside down mortgages, though, chances are you will not have to pay tax on the forgiven debt – check with a tax professional before or after you settle on your debts to find out specifics and how to file your tax return.

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