How debt settlement affects your taxes

What is debt settlement?

For borrowers who have racked up a lot of debt and don’t feel able to realistically pay it off, options may seem limited. If you just can’t get ahead and your income isn’t likely to increase enough to pay off debt in a timely fashion, debt settlement may be a solution.

Debt settlement or debt relief programs involve negotiating, often through a third-party debt settlement company, to pay less than the amount you owe to creditors. This can be a lifeline that offers you debt freedom for a lump sum, but this strategy has some caveats.

Debt settlement comes with the risk of lowering your credit score due to having to cease payments on your accounts during negotiations, according to the Consumer Financial Protection Bureau (CFPB). Not all creditors work with debt settlement companies, either.

However, if your debt is such that you owe multiple creditors and cannot budget your way out of the debt within a few years, you might seriously consider debt settlement. It can be a solid choice if you’re aiming to avoid bankruptcy and wipe out your debt sooner than otherwise would be possible.

» MORE: What is a charge-off?

Debt settlement and cancellation of debt income

There are pros and cons to consider with debt settlement. One potential downside may be how a debt settlement impacts your taxes. Jeremy Babener, a finance expert and founder of Structured Consulting, noted that the amount forgiven upon settlement is generally taxable.

Babener explained: “It's because you weren't taxed on the loan amount you received. But if it's forgiven, you just got a significant financial benefit, and you're taxed on that.”

Say you started with an outstanding debt balance of $12,000 and negotiated with the creditor to pay $8,000 to settle the debt. Your $4,000 in canceled debt is now taxable, unless it falls under any IRS exceptions to that rule.

The IRS views the amount your creditors release you from as cancellation of debt (COD) income. You’re required to add this to your taxable income, except in circumstances such as insolvency or bankruptcy.

» MORE: Everything you need to know about cancellation of debt (COD)

What is Form 1099-C?

IRS Form 1099-C is the official federal documentation of cancellation of debt. Creditors should send you this form if they’ve forgiven at least $600 in debt. It’s only for use if you actually incurred the applicable debt, which is likely the case if you’ve gone through debt settlement.

Babener noted that “COD income is taxable even if it’s below $600, though you probably won’t receive a 1099-C in that case.” You’ll want to keep careful records of any debt settlement or other form of debt forgiveness.

Be aware that even if there are errors on your 1099-C, it’s still your responsibility to report the correct amount of forgiven debt to the IRS during the applicable tax year. You should always review any Form 1099-C you receive and inspect it for accuracy. Contact the appropriate creditor if you receive a 1099-C that displays incorrect information.

Exceptions and exclusions of COD income

Not all forgiven or canceled debt is subject to taxation. Greg Maxwell, an attorney and certified financial planner, said, “The tax code has a few exceptions for COD income, including for bankruptcy, insolvency and when debt is being forgiven by those who sold you your house.”

Here are the exceptions to cancellation of debt income as outlined by the IRS:

• Gifts, bequests or inheritances
• Certain student loan cancellations based on employment
• Some student loans that were discharged between Jan. 1, 2021, and Dec. 31, 2025
• Student loan repayment assistance program amounts forgiven (in some cases)
• If your canceled debt would be deductible if you paid it as a cash basis taxpayer
• Purchase price reduction given by a property seller

If any of the exclusions apply to your canceled debt, you need to file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, along with your tax return.

Canceled debts that fit under those exceptions can be eliminated from your income total (not considered as canceled debt from a tax perspective). The IRS also provides exclusions, which are technically still canceled debts, but the IRS doesn’t tax you on them.

These exclusions include Title 11 bankruptcy, debt canceled to the extent insolvent, qualified farm debt, qualified real property business debt and certain qualified principal residence debt.

Consider the type of loan cancellation or forgiveness you’re looking for through debt settlement. Having to factor that amount into your taxes may not be pleasant, but it doesn’t necessarily mean a settlement can’t benefit you.

» MORE: How does debt consolidation work?

How debt settlement affects tax refunds

Since debt settlement results in some portion of debt forgiveness, you need to know how that dollar amount doesn’t completely disappear: it affects your taxable income.

Broadly speaking, increasing your taxable income will increase any taxes you may owe or reduce any refund you receive. However, if your income is hovering near the line between tax brackets, debt settlement that causes your taxable income to increase could have an even greater impact.

Because federal tax rates are progressive, meaning higher income ranges pay higher tax rates, your forgiven debt could have an outsized impact on your tax returns. This can’t really be helped, but if you’re working through debt settlement, you may wish to try and find ways of reducing taxable income to counteract any added taxation for the year.

Potentially increasing your taxable income is just one of the complications of debt settlement, making it far from an easy solution to your debt. Debt settlement is a big step that requires examination of all your options, as a higher tax bill or lower refund could cause additional financial struggle.

» MORE: Credit counseling vs. debt settlement

Bottom line

Debt settlement may offer a valuable lifeline if you’re unable to pay off debt using consolidation or another debt payoff method, but there are downsides to consider. Debt settlement affects your taxes, so be sure to factor that into your planning if you decide to pursue that route.

You don’t want to be caught by surprise with a large tax bill if you’ve had a large amount of debt forgiven. Consult with a tax advisor or financial attorney if you need guidance for your specific debt settlement circumstances.