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Although settling your debt provides peace of mind, you must understand the tax implications of settlement before you agree to it. Third-party settlement services may inform you about this. However, creditors may not inform you of tax issues when you settle your debt directly through them.

How Do Tax Consequences Work For Debt Settlement?

When you settle a debt, it is usually for a fraction of the original amount owed. The difference between the two amounts is a savings to you and can be considered the same as income in the eyes of the Internal Revenue Service. For example, imagine that you owe a debt of $700. If the creditor agrees to settle the debt for $300 with an upfront payment, that is a savings of $400 to you. The creditor will issue a 1099-C to you at the beginning of the following year, which shows the $400. You are required to report it as income on your personal tax return.

How Much Is The Tax For Debt Settlement Savings?

Unfortunately, there is no clear-cut answer to this question. Your tax liability depends on your income and the amount of cancelled debt. To determine what you will owe, consult the IRS Tax Table. Tax rates start at 10 percent, and some people in higher income brackets are charged over 39 percent because of the progressive rate system.

Does A 1099-C Have To Be Reported?

You are required by law to report all of your earnings including cancelled debts. When a creditor issues a 1099-C to you, the record is issued to the IRS as well. They have this information on file. Since records are kept in a sophisticated online database, agents who review your tax return may see that you did not report the 1099-C. You could be charged for the amount if they discover the error.

If you do not receive a 1099-C, you are still required to report any cancelled debts or the portions of balances that were forgiven. While the IRS is less likely to notice such an omission, you could be in financial trouble if you are audited. The cancelled debt will be discovered in an audit, and you could be charged interest and any applicable late fees for the entire time that the amount remained unreported to the IRS.

How Can I Avoid Tax Implications?

Paying the debt in full is the only way to avoid tax consequences. Creditors can write off cancelled debts to work in their favor financially. However, you are still left with more financial liabilities. If you cannot afford the tax consequences but debts are piling up, consider a consolidation loan instead. This option pays off your debts but leaves you with a single monthly payment.

If your debts are not too high and you have decent credit but want to avoid having the debt reported to a credit bureau, you can apply for a no-interest credit card. With some companies offering a no-interest introductory period of up to 18 months, you will have plenty of time to pay off a balance with a monthly payment of about $25 with no interest. Be sure that you can pay off the balance in time.

Also, you can try to work with the creditor to set up a payment program for smaller monthly payments if you are experiencing financial hardship. Most collection agencies and creditors are willing to work with you. Always consider your alternate options before you settle debts and face the tax consequences.