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Debt settlement has become a popular approach to
resolving problem debts without having to file
bankruptcy. With this approach, creditors agree
to accept a portion of what you owe (usually
around 50% or less) to settle the account, and
the remaining balance is forgiven. This
technique will certainly continue to grow in
popularity now that the new bankruptcy law makes
it tougher to fully discharge debts in a Chapter
7 bankruptcy.
As with anything, there is no free lunch, and
creditors are required to report canceled debts
to the IRS on Form 1099 (when the canceled
balance is $600 or greater). Therefore, the
possibility exists that you may owe taxes on the
forgiven portion of the debt. For this reason,
many financial writers and debt counselors are
strongly critical of debt settlement, to the
point where they actually recommend against it
just because you might end up owing taxes.
But the tax consequences of settling your debts
are greatly over-emphasized, and this is a
really just a minor issue at best.
First, even if you end up owing taxes on the
canceled balances, that's because you saved a
bunch of money off your original debts. The
total of what you paid the creditor, plus the
taxes, will still be much less than what you
owed to begin with. There is still a net
savings. So it's hard to understand why this is
viewed as a problem in the first place!
Second, the great majority of people who settle
their debts are not required to pay taxes on the
forgiven part of the balance. That's because of
the "insolvency" rule, described in IRS
Publication 908, "Bankruptcy Tax Guide." Don't
let the title fool you. You don't need to have
filed a formal declaration of bankruptcy to take
advantage of the insolvency rule.
Basically, "insolvent" means that you have a
negative net worth -- that is, you "owe" more
than you "own." As a consequence, most debtors
do not have a tax liability on the canceled
debts, simply because most debtors are
insolvent! It usually comes down to home equity.
If you have enough equity in a home (or other
property) to outweigh the total of your
liabilities (debts), then you have a positive
net worth, and will likely have to pay taxes on
the forgiven debt amounts. However, the majority
of people in serious debt trouble have a
negative net worth, and are therefore insolvent.
The way it works is that you can offset the
canceled debt up to the amount by which you were
insolvent at the time you did the settlement.
Come tax time, be sure to get professional tax
advice specific to your situation. Also, be sure
to read the section in IRS Publication 908 on
"reduction of tax attributes," which requires
people using the insolvency rule to reduce their
basis in such things as rental property, loss
carryovers, etc. Most of that probably won't
apply to you, but again, get specific advice
before winging it.
So, the message is, relax about paying taxes on
canceled debt balances. That should be the least
of your concerns if you're upside down
financially. Don't let the misguided criticisms
of financial writers (who haven't done their
homework) discourage you from looking into one
of the most popular and flexible options for
achieving debt-freedom.
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