What if you settle a debt? Are there tax consequences?
Maybe you received a collection letter in the mail, or maybe you got sued, and you settled by paying some money to the original creditor or the debt collector.
What are the tax consequences?
Let me give you the general guidelines.
There are exceptions to this, and some answers may have to be sought elsewhere, but with this information, you can at least have enough knowledge to ask the right questions.
Forgiven debt is taxable income to you
There’s a simple concept that says, “If there has been forgiven debt, meaning debt that you owed, but it has been forgiven, then that’s considered taxable income to you.”
You will receive a 1099 for that amount.
Here’s an example:
Let’s say you loan me $5,000.
I have $5,000 in cash. Do I pay taxes on that?
The answer is “no” because that’s money I’ve borrowed, and I’m going to repay that money with
$5,000 plus interest with “after-tax” dollars, so there’s no problem.
But what if you loan me $5,000, and I never pay it back? Or I pay you only $3,000 of the $5,000 I owe?
Well, what about the other $2,000?
If you and I settled at $3,000, and you say, “Fine. We’re done with the debt.” Then you have forgiven me $2,000.
So, next January, I would get a 1099 if you were a bank or a financial company stating that I have $2,000 in income.
Then you have to figure out what to do with the 1099.
So how do you avoid this? To some extent, you cannot avoid it.
If they have forgiven the debt, meaning you owed $5,000, you paid $3,000, so they forgave
$2,000, then they are supposed to notify the IRS.
If you are insolvent or have disputed debt that’s disputed in good faith
There is an exception for you if you are “insolvent.”
If your debts exceed your assets, then you may be considered insolvent.
So, if I owe $300,000, and I have $100,000 in assets, then I may be considered insolvent.
You may need to check the current regulations, but that may be a case where you do not have to pay taxes on it.
Again, talk to someone who does taxes.
If this is disputed debt, that is, debt that is disputed in good faith, then the IRS may say, “Well, even though there is this 1099, you do not have to pay taxes on this.”
Here are two examples. One is difficult to argue, and one is easy to argue.
It’s hard to argue if someone says you owe $5,000, and you paid them $3,000. It sure looks like you were forgiven $2,000 in debt.
But what if you are sued by a debt buyer, a debt collector, and they sue you for $5,000, and you paid them zero. Nothing.
Well, can they then say, “We forgave you $5,000 worth of debt?”
It’s like, “What are you talking about? You didn’t forgive me anything. I never owed it.”
So, when I’m representing clients, if we’re dealing with a debt buyer, we don’t pay them any money.
Now, if they want to settle, or dismiss the case with prejudice, which means that the case is over. It’s done. It’s finished. And we never paid them a penny.
I’ve not had that problem before, but if I did, I certainly would talk to the tax preparer, the CPA, and say,
“Look, here’s the deal. My client got sued for $5,000. We paid zero. There wasn’t any forgiveness. They just gave up. If we truly owed the money, why would they give up before trial? And take zero?”
Now, I’ve had these debt buyers say to me,
“Well John, throw us a bone. Pay us $500 or $1,000 on a debt that’s $5,000.”
If we do that, then there’s a pretty good argument that they forgave us $4,000 in debt, which would then be taxable.
If I originally owed $5,000, and I paid $1,000, it’s not that I paid $4,000 in taxes, it’s that I paid taxes on $4,000 of income unless there is some exemption.
So, I just want you to be aware of this.
You’ll start getting settlement letters, particularly during tax refund season because they know that for some of us, this is when we get our money in.
So, these creditors or debt collectors are saying, “Pay me! I’ll give you a great deal,” and they will file a whole bunch of lawsuits thinking you’re going to have money at that time from your tax refund.
So, it’s fine to settle. You have to use your own judgment and ask, “Is this something I owe?”
“Is this a good deal?”
“What are the consequences of credit reporting?”
But I also want you to always understand that there may be tax consequences, and you need to figure that out.
Either get with a lawyer in your state, get with a CPA, get with somebody, and figure out if this is going to happen.
Here’s what I don’t want you to do:
I’ve had people come to me and say, “Last year, there was a $25,000 debt, and they gave me this fantastic deal.”
Maybe it was too old to sue, but they said they would let me settle for $5,000. And that’s wonderful!
But then they get a 1099 for $20,000.
So, depending on the tax bracket, that may cost you $5,000-7,000 in actual money. So just be aware of this.
I’m not saying you shouldn’t settle, but I’m saying you need to be aware of what can happen.
Go in with your eyes wide open so you know what tax consequences are possible. Just make sure that you have the knowledge, and then you can make a good decision.
Reach out to us if you are in Alabama!
If you are in Alabama, feel free to reach out and we can chat about what happened and whether the collection or credit reporting you are facing now is legal or illegal.
Always feel free to call us at 205-879-2447 or fill out our contact form.
Here is an article about settling an original creditor lawsuit against you.