Debt Settlement And Tax Consequences

Are you Broke?

When someone can no longer meet his/her personal responsibilities with lenders as bills come to be due, the person is Insolvent.

The above is vital to consider if engaging in debt settlement with credit card companies. Debt settlement is when you bargain with creditors to pay a portion, for example 25%, of the whole debts as payment in full, thus avoiding bankruptcy. When this takes place, you need to keep an eye out for the taxman. The IRS considers the 75% net savings as income. The reason is that when you received the borrowed money, you did not pay tax, and you would have had to repay the debt applying future earnings.

However, if you were insolvent, where your total liabilities exceed your assets, at the time of your debt forgiveness, then you may eliminate a portion or the whole amount of the tax owed. The key point to remember here is, “at the TIME of the debt forgiveness.” It is therefore very important to understand your level of insolvency when you reach a settlement with a creditor.

Per the IRS, below are two examples of insolvency:

Example 1
Amount of insolvency more than canceled debt.
Greg was released from his obligation to pay his personal credit card debt in the amount of $5,000. Greg received a Form 1099C from his credit card lender showing canceled debt of $5,000. Greg’s total liabilities immediately before the cancellation were $15,000 and the Fair Market Value (FMV) of his total assets immediately before the cancellation was $7,000. This means that immediately before the cancellation, Greg was insolvent to the extent of $8,000 ($15,000 total liabilities minus $7,000 FMV of his total assets). Because the amount by which Greg was insolvent immediately before the cancellation exceeds the amount of his debt canceled, Greg can exclude the entire $5,000 canceled debt from income.

Example 2
Amount of insolvency less than canceled debt
Assuming the same facts as above, let us say that Greg’s total liabilities immediately before the cancellation were $10,000 and the FMV of his total assets immediately before the cancellation were $7,000. In this example, Greg is insolvent to the extent of $3,000 ($10,000 total liabilities minus $7,000 FMV of his total assets) immediately before the cancellation. Because the amount of the canceled debt exceeds the amount by which Greg was insolvent immediately before the cancellation, Greg can exclude only $3,000 of the $5,000 canceled debt from income under the insolvency exclusion.

The following website, www.johnceesfreedom.com, provides an insolvency calculator that mirrors the IRS guidelines for figuring out if you owe taxes at the time of your debt settlement. You will also find a calculator that shows your debt to earnings ratio. This alternative calculator will show you the amount of debt you should get rid of in order to become financially fit.

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