A client called us the other day and asked, "Do you have to pay tax after settlement?"

In most cases, the answer is NO.

When you negotiate a settlement on a debt you owe, let's say a credit card with a $10,000 balance is settled for $4,000 (yes it is very possible!), the amount that is FORGIVEN may be added back into your taxable income for that year.

At the end of the year, you will receive a 1099-C in the mail that states that the creditor has reported the $6000 of forgiven debt to the IRS (any amount forgiven over $600 may be subject to IRS reporting).

What do you do when you receive a 1099-C?

First, if your accountant or tax preparer tells you that you will have to pay tax on that amount, you probably need to find a new accountant!

Why?  It has been my experience that most accountants and tax preparers are not aware or experienced in how to treat 1099-C for settlements or forgiveness.

IRS Form 4681 explains that certain amounts of "forgiven debt" may be excluded from taxable income.  Basically, if AT THE TIME OF FORGIVENESS, you were INSOLVENT (your debts were greater than your assets), then the forgiven amount IS NOT included as taxable income.

List all of your assets:

• Any equity you have in your home
• Net or depreciated value of your cars, boat, etc.
• Net value of your jewelery, stocks, bonds, etc.
• Cash

Now list all of your debts:

• Mortgage (First and Second) on your home
• Lines of credit
• student loans
• credit cards
• medical bills
• personal loans

Subtract the DEBTS YOU OWE from your ASSETS.  If the number is negative, then you are "insolvent" according to the IRS. Complete IRS Form 982 and check the appropriate boxes to show that this amount should be excluded.

The moral of this story, don't think that just because your accountant or anyone else tells you that you must automatically pay tax after settlement, that it is always true.

photo by: Alan Cleaver

If you have had a debt "forgiven", and receive a 1099-C, how do you avoid paying taxes?

Any amount of "forgiveness" over $600 can be reported to the IRS and if so, then you would receive a 1099-C form.  The IRS says that any debt that is settled for less than the full balance must be included back into your income and you must pay the resulting taxes!

Instructions from the IRS can be found in IRS 4681.

In the instructions, you will find an explanation of "INSOLVENCY".  Of course, when reading anything from the IRS, it is not very easy to understand or interpret.

Basically, the information states that if at the time of the forgiveness, you were INSOLVENT, then the amount of forgiveness IS NOT INCLUDED as additional income and therefore you would not pay any additional tax.

Let's look at an example:

After many harassing phone calls from your creditor, you are able to settle your account for less than the balance.  When it came time to file your taxes, you receive a 1099-C which would lists the debt, the debtor and the amount that was "forgiven".

What do you do now that you have received a 1099-C?

First you need to determine if you were INSOLVENT at the time the debt was forgiven. To determine if you were insolvent :

1.  List all of you assets (things you own that has positive equity):

• Equity of your home
• Net (depreciated) value of your cars, boat, etc.
• Net value of jewelery, stocks, bonds, etc.
• Savings or investment accounts
• Cash in the bank

2.  List all of the debt you had at the time of forgiveness:

• Mortgage (1st and 2nd)
• Auto, boat or other loans
• Credit card debt
• Medical debt
• Personal loans to...

3.  Now subtract your LIABILITIES (that's all the debt) from your ASSETS.

Is the result a NEGATIVE number?  If so, you WERE INSOLVENT!

When filing you tax return, you will need to complete IRS form 982 and submit with your tax return.  Most accountants and/or tax preparers are not aware of the exceptions to paying tax on "forgiven" debt, so you need to be very careful.

Although we are not attorneys nor tax accountants, we can help guide you through the process.

If you would like a FREE CONSULTATION, just let us know.

BOTTOM LINE...DON'T PAY ANY MORE TAX THAN YOU ARE LEGALLY REQUIRED...IT'S YOUR MONEY AFTER ALL!!!

 photo by: MoneyBlogNewz