The promise to settle thousands in unpaid balances for pennies on the dollar is the dream of countless consumers, and the promise of hundreds of late-night advertisers. In fact, if there's one debt reduction technique that gets the lion's share of press coverage, its debt settlement.

But before you pick up the phone and sign your life away, it's important to understand that there can be major tax consequences to having your debts forgiven. More than a few consumers have had significant debts canceled, only to find out that their forgiven balances count as additional taxable income on their annual returns. In a worst-case scenario (someone in one of the top tax brackets), the resulting IRS bill could easily be $300-400 for every $1,000 forgiven. (Learn legal strategies for saving more on taxes, read Safe Tax Planning For High-Net-Worth Filers.)

The Tax Consequences of Debt Settlement
While it may seem unfair, the IRS has no qualms about including amounts forgiven by your creditors as income on your tax return. In their eyes, the forgiven amount went from being a loan to income the moment you were no longer required to pay it back. However, the amount that can be included in your income may be reduced or completely eliminated in certain circumstances, most of which will require you seeking out professional tax help to ensure that your calculations are accurate.

The "exceptions," as they're officially known, fall into three general categories:

  • Certain Student Loans – Certain professions, such as teachers, doctors and nurses may have some or all of their balances forgiven under government and nonprofit programs. The amounts forgiven under these programs are not included as income.
  • Forgiveness as a Gift – Loan amounts forgiven as a gift are not subject to income tax. However, They may be subject to gift and estate tax.
  • Deductible Debt – Expenses that would have otherwise been deductible on your tax return may be excluded from income.

The amounts forgiven by your lender will be reported to you on IRS Form 1099-C after the end of the calendar year. As with all 1099 forms, this is the starting point from which the exceptions above are subtracted, as well as the "exclusions" covered below.

Tax-Free Debt Settlements
Never let it be said that the IRS doesn't have a heart. In fact, when it comes to debt settlements, there are a number of situations in which the IRS will give you a free pass. These situations are confusingly named exclusions, as opposed to the above-mentioned exceptions, (which only reduce the amount you owe). If you fall into one of these categories, the entire amount of the debt forgiven is excluded from your income.

  • Mortgage on Principal ResidenceThanks to the Mortgage Forgiveness Debt Relief Act of 2007, debts forgiven are not counted as income if the loan was taken out for the purchase or improvement of your primary residence. Unfortunately, money borrowed against your home and used for other purposes, such as paying off other debts, can still be included as income if forgiven. This rule is also subject to IRS limitations on the amount of debt forgiven (currently $1 million per individual).
  • Insolvency – The IRS generally allows taxpayers who immediately owe more than their net worth, prior to a debt cancellation, to exclude the forgiven amounts from their income. In other words, if you owe $25,000 but only have assets of $10,000 right before a debt is canceled, it's likely you'll be able to exclude the amount from your tax return.
  • Bankruptcy – If someone has filed a Chapter 11 bankruptcy and certain debts are canceled under a bankruptcy court order, those debts can generally be excluded from your income as well. (To learn more read, Life After Bankruptcy.)
  • Farming and Business Real Estate – The IRS allows debts related to professional farming as well as real estate purchased as part of a business to be excluded from income when forgiven.

Forgiven debts totaling $600 or less can be excluded from your income. The IRS rule actually states that a company does not have to provide you with a 1099-C at the end of the year if your forgiven debt was less than $600. This does not exempt taxpayers, and any forgiven debts not subject to the above exceptions and exclusions must be included in your income, regardless of the dollar amount.

Deciding to Settle
There's no doubt that adding in a complicated tax discussion can make a debt settlement decision feel even more overwhelming. Not only do you have to consider the effects of the debt settlement on your credit score and available cash, but you also have to decipher whether or not a tax bill will make an already difficult situation worse. If you're going to owe the IRS big money, you'll want to think about it much more carefully. In hindsight, many people who have been unable to pay their tax bill from a settlement have realized that it's far more preferable to have general creditors breathing down their necks than it is to be in the spotlight of the IRS. (For more on this, see The Importance Of Your Credit Score and Digging Out Of Personal Debt.)

That's not to say that you shouldn't do a debt settlement if you can't pay the full tax bill. Rather, you should talk to your tax professional about the possibility of doing a debt settlement with your creditor and then making an "offer in compromise" down the road to the IRS. These offers are debt settlements for money owed to the IRS and can cut down the amount owed by 50% or more.

Pay for Good Advice, but Make the Offer Yourself
Debt settlement and taxes are tricky affairs. Though you might understand the general idea behind the exclusions, exceptions and the amount owing, it's strongly recommended that you seek out professional tax advice. There'd be nothing worse than thinking you've dodged a bullet from the IRS, only to get that dreaded letter months later. (To learn how to negotiate see, Negotiating A Debt Settlement.)

If you get the green light from your tax pro, be sure to try and make the debt settlement offer yourself before paying a debt settlement agency to do it for you. Many of these companies end up charging thousands of dollars in fees, while creditors are just as willing to deal with you directly.

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