Our article on 10 crucial debt
reduction mistakes was posted on the Don't Mess
with Taxes blog at: www.dontmesswithtaxes.typepad.com and it has become quite popular in terms of viewership. However,
the point we made needs further elaboration and explanation.
In this article, we will do just that!
Forgiven Debt is Taxable Income
If you have had a debt settlement agreement with your debtors
where they wrote off your debt, this automatically creates taxable
income for you! According to IRS Form 980, if you receive a
debt settlement of $600 or more, it will automatically be reported
to the IRS and the beneficiary of this settlement will have
to include this forgiven debt in his taxable income. Therefore,
if you have had a large portion of your debt forgiven, you should
not be totally happy because you will have to pay tax on this
amount!
Is forgiven debt really a taxable income?
Suppose you owe your credit card company $12000 in credit card
debt. You carry out a debt negotiation process with Visa or
MasterCard and get them to reduce your credit card debt balance
from $12000 to $7000. While Visa has lost $5000 ($12000 - $7000),
the IRS has earned itself taxable revenue of $5000. That's right,
this $5000 balance which you did not pay is known as Discharge
of Indebtedness, or DOI income and you will be taxed
on this amount! As a matter of fact, the debtor will issue you
a Form 1099 which will detail the debt reduction benefits that
you received.
What if the debtor forgets to send you a Form
1099? Does this mean the reduced debt amount you received (i.e
$5000) is not taxable? No! Even though the debtor hasn't sent
you a Form 1099, the taxable income may have been reported to
the IRS. This means you will have to be honest and include this
income in your tax return, at the end of the year. Barbara Weltman,
a Tax Attorney and Author of J.K. Lasser's Tax Savings
in your Pocket quotes, "Any debt that is forgiven
is counted as income, and you owe taxes on the amount that's
forgiven."
Steve Rhode, Co-Founder of MyVesta (a debt
consolidation & credit counseling firm) says, "It's
a great way for the IRS to make money." What does this
mean for you both as a taxpayer and as beneficiary of debt reduction?
Should you therefore not let your credit card company reduce
your debts because you will have to pay extra tax if they do
so? Well it depends, you have to look at it from different angles.
Barbara Weltman says, "What you have to do is recognize
you'll have to pay taxes and factor that into your negotiations
and your financial planning." Will the extra taxable income
you receive push you into a higher tax bracket, thus forcing
you to pay even higher taxes? Or will you still be in your current
tax bracket and be able to handle the extra tax payments you
will have to make?
There are 3 situations under which forgiven
debt is NOT included in your taxable income:
1) Battled Contest
If you dispute an amount charged on your credit
card and win the debt settlement, you are excluded from the
Discharge of Indebtedness (DOI Income) rule. For example, Visa
might say you owe $1500 in credit card debt due to a recent
purchase of expensive shoes. You know you haven't purchased
those shoes and dispute the bill and the court case goes on
for weeks. In the end, you agree to pay Visa $150 to reach a
debt settlement. Since your debt owed has legally been reduced
from $1500 to $150, you would be liable
for the DOI income rule. However, since you won this case by
a protest or a dispute (in court or verbal settlement), you
are NOT required to include this amount as
part of your taxable income.
2) Bankruptcy Declaration
When you've declared bankruptcy and are making
for example only 10% of the original debt payments you owed,
the other 90% is excluded from the Discharge of Indebtedness
Income rule.
3) Insolvent Financial Condition
When you are insolvent, meaning your liabilities
owed exceed your total assets, you are not required to pay any
tax on any debt reduction or debt settlement benefits you receive. |
