Settling your debts for less than you owe seems like a great financial move. But don't overlook the tax man when weighing the pros and cons of debt settlement. The IRS views settled debt as income, which could leave you with an unexpectedly high tax bill.

Understanding the tax implications is crucial before pursuing debt settlement. With proper planning, you may be able to minimize or avoid taxes on settled debt.

The IRS Considers Settled Debt As Taxable Income

When a creditor or debt collector agrees to let you pay a lump sum that's less than your total owed balance, the IRS considers the amount forgiven as income. You essentially earned money by settling the debt.

For example:

• You owe $10,000 on a credit card

• You negotiate a settlement to pay $4,000

• The credit card company writes off the remaining $6,000 balance

• The IRS sees that $6,000 as income you must report

These tax rules apply to most types of settled debt, including:

• Credit cards

• Medical bills

• Personal loans

• Payday loans

• Private student loans

Certain exceptions exist, mainly for mortgage debt relief under the Mortgage Forgiveness Debt Relief Act. But for the most part, expect to pay income tax on any amount forgiven from a settlement.

When Do You Have to Pay Taxes on Settled Debt?

The tax timing depends on when the creditor formally agrees to forgive the debt:

• If forgiven in the same year paid, it's taxable that year

• If forgiven after settling in a previous tax year, it's taxable in the year forgiven

For example:

You settle a credit card in 2022 for $5,000 and the remaining $3,000 balance is forgiven in 2023. You must claim the $3,000 as income on your 2023 tax return.

The 1099-C form creditors send details of the timing and amount forgiven. Save this form to report accurately on your tax return.

How Is Forgiven Debt Taxed?

Settled debt gets treated as ordinary income, just like your wages. So expect to pay regular federal and state income tax on the forgiven amount, based on your tax bracket.

You'll also owe the 15.3% self-employment tax on the income since it didn't come from a job. The only saving grace is that settled debt doesn't count as earned income for Earned Income Tax Credit (EITC) purposes.

Here’s how it could add up to $5,000 of forgiven debt:

• Federal income tax: $650

• State income tax: $300

• Self-employment tax: $765

• Total extra taxes owed: $1,715

That turns a $5,000 settlement into a $3,285 savings, at most. Still, decent savings, but tax considerations make the benefit less attractive.

Check Out: Top Debt Settlement Companies 2023

Strategies to Avoid Taxes on Settled Debt

You aren't necessarily stuck paying taxes on debt settlement. Savvy planning can eliminate or reduce the tax bite:

Negotiate with Creditor Upfront

If the creditor doesn’t issue a 1099-C, the IRS has no way to know about the settled debt income. When negotiating debt relief, ask the creditor not to report it. Get any no-1099 agreement in writing.

This works best with smaller, individual creditors, like doctor’s offices or retailers, versus big banks. But any non-reported settlement means avoiding taxes.

Claim the Insolvency Exclusion

Tax filers can exclude forgiven debt from taxes if they were insolvent at the time. Insolvency means your total debts exceed the fair market value of your assets. You can claim the insolvency exclusion up to the amount you were insolvent.

To qualify, submit IRS Form 982 along with proof of your insolvency, like a balance sheet, when filing your taxes. If approved, you can exclude part or all the settled debt from taxes.

Negotiate Before Default

Another exception exists for debt settled before it ever goes into default. That’s because the tax laws refer to forgiveness of debt, implying you first defaulted. Settling accounts promptly before they become delinquent avoids this scenario.

Again, get written confirmation from the creditor that your timely settlement satisfies the debt. Paying debt under agreed terms, even at a discount, means there’s no taxable forgiveness.

Learn: Why Debt Settlement Outshines Credit Repair

Weighing Debt Relief vs Tax Burdens

Settling debt often makes solid financial sense despite the tax consequences. You eliminated high-interest debt for a fraction of what you owed. But don't underestimate the tax impacts.

With smart timing and negotiation tactics, you may avoid extra taxes and keep all your settlement savings. Understanding the nuances of debt settlement taxation allows leveraging this option without unnecessary tax burdens.