Tax Consequences of Debt Settlement in Northridge, CA

Also known as ‘debt adjustment’ or ‘debt relief’, debt settlement relates to settling your outstanding debt; for example, your credit card payable amount or a business loan, for less amount than originally owed to the creditor. This is usually done by agreeing to pay a lump sum amount that is often significantly less than the original amount due. At times, your creditor may simply stop making efforts to collect debt in case, for example, you become bankrupt with no hope of making the payment.

In other cases, you may be asked to pay anywhere from 10% to 70% of the outstanding amount in exchange for settlement of the whole debt.

While getting a debt settlement looks good for a while, it can have serious consequences in the near future. For example, debt settlement is reflected in your credit report, which ultimately goes on to damage your credit rating/ score. But more importantly, there may be serious tax consequences of debt settlement in Northridge, CA, as well as other parts of the United States.

Let’s look at these tax consequences of debt settlement in further detail.

Tax Consequences of Debt Settlement in Northridge, CA

If your creditor allows you a tax settlement for a discounted payment, your creditors will claim the lost amount of money as their expense for tax purposes. Hence, they get partial relief in the form of reduced tax liability on their part. But in your case, the IRS shall treat non-payment of outstanding debt as your income and ask you to pay additional tax on this amount. 

Suppose you had a payable amount of $20,000 against your credit card usage, but your financial circumstances deteriorated, and you became unable to pay the whole amount. Your credit card provider agrees to settle the whole debt if you pay only $12,000. Since the offer seems attractive, you somehow managed to gather $12,000 in order to settle the whole debt of $20,000. The credit card company shall treat this $8,000 loss in debt collection as bad debt and claim it as a tax-deductible expense with the IRS. 

Now the IRS has lost tax revenue on $8,000, but it will try to recover this tax from you. It is treated as if you bought goods worth $8,000 for your use but didn’t pay any tax on it. 

For a debt of $600 or more, the creditor issues a 1099-C tax form when it agrees to settle the debt. This form tells about the exact debt settlement benefit you received in dollar terms. Now the IRS shall have its eyes on you for taxing you on this amount.

So, if you receive a tax settlement, be prepared to see this amount appearing on Line 21 of the upcoming tax returns, under the head of “other income”, and, ultimately, on Line 43 under the head of “taxable income.”

How Mortgage Forgiveness and Debt Relief Act 2007 Provides Relief in Northridge, CA?

While the tax consequences of debt settlement in Northridge, CA, and other parts of the country are substantial, there may be certain reliefs/ exceptions. The Mortgage Forgiveness and Debt Relief Act 2007 has been the major exception in this regard. This Act provided temporary relief to those who had mortgaged their property or used a loan to build, buy or improve their residence. Similarly, certain exceptions may be available in the following situations:

1. Loan has been regarded as a gift.
2. The debtor becomes insolvent.
3. The debtor has filed for bankruptcy.
4. The debt has been cancelled by a qualified individual.
5. The debt has been qualified as ‘principal residence indebtedness.’
6. The loan was forgiven under a ‘student loan cancellation’ program.

Overall, the amount of increase in tax liability will always be less than the settlement amount. So, you must always be honest in reporting the forgiven debt. 

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