What are the Tax Implications of My Unsecured Debt?

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Ladies and gentlemen, welcome to tax season! If you have recently made the decision to settle your debt, you likely have a lot of questions: how can you be certain you’ve chosen the most reliable and trustworthy debt settlement company? What steps you will have to take next? How does debt settlement work? How much will it cost? If you’re feeling overwhelmed, you are certainly not alone.

Debt settlement is among the quickest, most efficient strategies to achieve financial freedom, but like any other strategy, it’s important to know what you’re getting into. One consideration of debt settlement is the possibility of owing taxes after you have settled your debt. It is always a good idea to speak to your accountant if you have any concerns.

Tax Consequences

If you enter a debt settlement program there is a chance you will owe taxes after the debt has been settled. For this reason, it’s important to learn as much as you can about possible tax implications before you move forward with a debt settlement company.

Tax implications of unsecured debt occur because of a particular law that financial institutions need to follow. If you cancel any debt over $600, your bank will take notice, and they are required by law to report it as “canceled debt.” When debt is forgiven during settlement, financial institutions view it as a type of canceled debt. In addition, a debtor is required to report the forgiven debt as income on their next tax return.

How Your Net Worth Factors In

The IRS views canceled debts as taxable income, but fortunately, for most people with a negative net worth, they will also allow you to offset any of that income up to the amount you were insolvent at the time your debts were forgiven. What does it mean to be “insolvent”? It means you owe more money than you have.

Most people who are heavily burdened by debt do not have a positive net worth. If you fall into this category, you will probably not be required to pay taxes on your forgiven debt.

Having a high level of home equity is the most common exception to the insolvency loophole. If you have a lot of equity in your home, you might be surprised to learn that you are excluded from insolvency. If this is the case, you are expected to pay taxes on your forgiven debt after all.

Insolvency Exclusion

In short, if your debt liabilities are currently greater than the value of your assets, you are likely to receive tax relief from the IRS, who explain it best themselves:

“A debtor is insolvent when, and to the extent, the debtor’s liabilities exceed the FMV [fair market value] of the assets. Determine the debtor’s liabilities and the FMV of the assets immediately before the cancellation of the debtor’s debt to determine whether or not the debtor is insolvent and the amount by which the debtor is insolvent.

“Exclude from the debtor’s gross income debt canceled when the debtor is insolvent, but only up to the amount by which the debtor is insolvent. However, you must use the amount excluded to reduce certain tax attributes” (Publication 908).