Debt Prison

The amount of debt you settle may be taxable by Federal and State Government. Most people are not aware that if the amount of settled debt surpasses $600, the IRS considers this taxable income. If you have settled with a creditor on a debt, they should send you a 1099-C tax form. This form will list the amount of forgiven debt and the interest. This was a surprise to me: the idea of our government demanding payment from those of us who can least afford to give (sarcasm intended). The IRS last updated Publication 908, which states in regards to settled debt, or forgiven debt, if a debt is cancelled or forgiven the debtor generally must include the forgiven amount in gross income for tax purposes.

See also, all of my articles on collection agencies.

Now keep in mind that debt that is discharged due to bankruptcy is not considered forgiven debt, according to Publication 908. So if you filed bankruptcy on some debt, those forgiven debt amounts are not considered income by the government. However,

If the amount of debt you owe is greater than your assets, meaning you are insolvent, the IRS does not require you to report the forgiven debt. But, you cannot exclude any amount of forgiven debt that is more than the amount by which you are insolvent.

So if you owed Bank of America $6,000 and they settled for $2,500 (you lucky dog), then you could expect a 1099-c from BOA explaining the forgiven debt of $3,500. See also, How to Settle Your Debts on Your Own.

What if you decide not to report it?

Hey no problem if you don’t want to claim this forgiven debt as income… however, you should know that the IRS was also given a copy of the 1099-c by BOA… so they know about the income. Maybe they’ll just flag you for an audit.

3 Instances when you don’t have to claim forgiven debt

This is from www.3debtconsolidation.com

There are 3 situations under which forgiven debt is NOT included in your taxable income:

1) Battled Contest
If you dispute an amount charged on your credit card and win the debt settlement, you are excluded from the Discharge of Indebtedness (DOI Income) rule. For example, Visa might say you owe $1500 in credit card debt due to a recent purchase of expensive shoes. You know you haven’t purchased those shoes and dispute the bill and the court case goes on for weeks. In the end, you agree to pay Visa $150 to reach a debt settlement. Since your debt owed has legally been reduced from $1500 to $150, you would be liable for the DOI income rule. However, since you won this case by a protest or a dispute (in court or verbal settlement), you are NOT required to include this amount as part of your taxable income.

2) Bankruptcy Declaration
When you’ve declared bankruptcy and are making for example only 10% of the original debt payments you owed, the other 90% is excluded from the Discharge of Indebtedness Income rule.

3) Insolvent Financial Condition
When you are insolvent, meaning your liabilities owed exceed your total assets, you are not required to pay any tax on any debt reduction or debt settlement benefits you receive.

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* Restrictions on Wage Garnishment for Debt Collection.

* The Fair Debt Collection Practices Act

* Reasons not to file Bankruptcy or Settle Your Debts

* Can you go to jail for not paying your debts?

* How to settle your debts on your own

* How to deal with collection agencies

* Sample Debt Validation Letter