Settling a debt for less than what you owe can feel like a massive victory. It lifts a weight off your shoulders and offers a fresh start. But then, tax season arrives, and you receive a Form 1099-C in the mail. Panic sets in as you realize the IRS treats forgiven debt as taxable income. Suddenly, you are searching for "how to avoid paying taxes on debt settlement."
The good news is that you are not automatically doomed to pay a huge tax bill. The IRS provides specific exceptions that can reduce or completely eliminate this tax liability, but you have to know how to claim them. The most common method is the Insolvency Exclusion.
According to the IRS, if you were "insolvent" immediately before the debt was cancelled, you do not have to include the forgiven debt in your income. Insolvency is a fancy financial term that simply means your total liabilities (everything you owe) exceeded your total assets (everything you own). For example, if you owned $5,000 worth of stuff but owed $15,000 in debts, you were insolvent by $10,000. If the bank forgave $4,000 of debt, that entire amount could be excluded from your taxes because it is less than your insolvency amount.
To claim this, you generally need to file IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) with your tax return. This form tells the IRS, "Yes, I had debt forgiven, but I was broke when it happened, so please don't tax me on it."
Another exception applies to debts discharged in bankruptcy. If your debt was wiped out through Chapter 7 or Chapter 13 bankruptcy, it is generally not considered taxable income.
Navigating Form 982 and calculating insolvency can be tricky. It requires listing out the value of your car, furniture, bank accounts, and comparing it to your debts. However, taking the time to do this correctly can save you thousands of dollars.
Don't let the IRS take your hard-earned savings. Get the full guide on handling debt taxes and learn more here.