Taxes on Forgiven Debt?
Clients often speak with a "Debt Management Company" before they come to see me. Apart from the fact that the savings usually end up being a whole lot less than they appear to be (see my blog, "Are 'Debt Management Programs' a Scam?"), there's one aspect that they almost never talk about: tax consequences.
The IRS has long taken the position that if you have debt that is forgiven, the amount of the forgiven debt is actually considered income! As it says in Tax Topic 431: Canceled Debt -- Is It Taxable Or Not?:
In general, if you have cancellation of debt income because your debt is canceled, forgiven, or discharged for less than the amount you must pay, the amount of the canceled debt is taxable and you must report the canceled debt on your tax return for the year the cancellation occurs.
So, if you owe Capital One a $25,000 credit card debt, and you agree to settle it for a lump sum of $10,000, Capital One is "forgiving" $15,000. The IRS considers this $15,000 as "income" to you, the same as if you got a check from Capital One for this amount.
And you have to pay federal and state income taxes on the $15,000 just the same as if Capital One actually did send you a check. Capital One will send you a 1099-C at the end of the year, with a copy to the IRS.
Is it fair? No. But it is the law.
Now there are a few exceptions, that are covered in the Tax Topic linked to above. But you have to apply for the exception, and the IRS has to agree that your interpretation or status is such that it will grant them. So be careful when settling debt.
By the way, one of the stated exclusions from income? If you discharge debt in bankruptcy.