Debt Forgiveness and Tax Consequences

Debt forgiveness is sometimes the only chance people have. It can be a wise decision in some circumstances, but before you agree to those terms, there are some things you should know.

Why Do People Settle Debt?

There are times when you’re able to settle directly with the creditor concerning a balance that you owe. Very often that settlement will involve paying less than the original balance to that creditor. Now that can be a good thing. It can increase your credit score by not having a delinquent account reporting anymore, and it can reduce your personal stress by not having that creditor pursue you

Be Careful: The Credit Doesn’t Tell You This
One thing the creditor may not tell you is that settling a debt can create a tax consequence to you. The reason is because the Internal Revenue Code, which are the rules that the IRS goes by, says that if someone forgives a debt to you and says you no longer owe that money, that becomes taxable income to you, just like money you get in your paycheck is taxable income to you.

Learn From My Client
So I had a client recently, she had some debt that she was able to negotiate a settlement directly with a creditor for, for a guarantee she had given on a business that she used to be a part of, and that business later went under.

Her guarantee agreement was still enforceable, so the bank pursued her for the remaining balance they hadn’t been paid from that failed business. What they didn’t tell her was that at the end of the next year, she was going to get a form 1099 from them. She took that form 1099(c) to her accountant, and her accountant told her she owed more in taxes now because that was taxable income, even though she had not received any actual money from them. So she had not accounted for that additional tax debt in her financial planning, and it caused her a lot of additional stress trying to figure out how to pay this new bill she hadn’t counted on.

If you have any other questions concerning this topic, send us an email at [email protected].

Donald Hedervare
About the Author: Donald Hedervare
Donald J. Hedervare, Jr. has been practicing in the areas of bankruptcy law, student loan law and military justice for 17 years. He is a member of the Minnesota State Bar Association, the Ramsey County Bar Association, and the National Association of Consumer Bankruptcy Attorneys.