If you have accumulated debts that you cannot pay, bankruptcy may not be your only option. In the Oklahoma City area, if you have debts that you can’t pay, an Oklahoma City debt relief lawyer will examine your financial situation before suggesting any particular debt relief option.

For many people who are deeply in debt, debt settlement is a practical alternative to bankruptcy. You should discuss the debt settlement approach with your debt relief lawyer, and you should ask that lawyer to negotiate a debt settlement on your behalf, if you:

  1. want to pay off a debt but cannot satisfy the creditor’s terms
  2. want to pay less to discharge debts than you would pay with a Chapter 13 bankruptcy
  3. are precluded for any reason from filing for bankruptcy

If you settle a debt for less than you owe, you will probably end up owing the Internal Revenue Service (IRS) a tax on the amount you did not pay. Keep reading to learn the details and to find out more about debt settlements, your taxes, and your rights.

What is Debt Settlement?

Debt settlement happens when a debtor (or an Oklahoma City debt relief lawyer working on a debtor’s behalf) negotiates with creditors to settle debts for less than the amount that is owed. Debt settlement does not eliminate debt; it reduces debt to make it manageable.

A creditor will not settle a debt unless you can prove financial hardship. If creditors believe you can pay your debt in full, they will not negotiate a settlement. An Oklahoma debt relief attorney will help you prepare the evidence to prove to your creditors that you need a debt settlement.

What Are the Tax Ramifications When Creditors Write Off or Settle Debts?

Under IRS rules, a loan isn’t “income,” and payment on a loan may not be used as a deduction. However, any amount you save on a settled, canceled, forgiven, or written off debt is considered taxable income by the IRS.

Here’s how that can work: When a creditor cannot collect a debt, that creditor typically writes off the debt one, two, or three years after you have defaulted. Collection efforts cease, and the creditor declares the debt as uncollectible and reports it as lost income to the IRS.

That means the uncollected amount is considered taxable income. The same thing happens if you and your attorney negotiate the reduction of a debt. The creditor reports to the IRS the amount you did not pay, and that amount becomes taxable income.

How is a “Double Penalty” Created by a Debt Settlement?

When large debt amounts are settled, your additional taxes could amount to thousands of dollars. You may owe the Internal Revenue Service a considerable tax debt.

Financial problems are usually the cause of repossession, foreclosure, medical debts, or credit card debts, so a tax on a settled debt is essentially a “double penalty” which adds another burden to a person who already has financial troubles.

But the news is not all bad. The IRS allows some taxpayers to exclude some of their canceled debt “income” in several particular circumstances.

Are You Eligible for an Exclusion on Canceled Debt?

There are several situations that allow canceled debts to be excluded from your taxable income and do not require you to pay a tax on the canceled debt.

For instance, under the Mortgage Debt Relief Act of 2007, you do not have to pay tax on a canceled mortgage signed between 2007 and 2016. The IRS excludes canceled debt from your total taxable income if the canceled debt is the result of:

  1. qualified principal residence indebtedness
  2. qualified farm indebtedness
  3. qualified real property business indebtedness
  4. bankruptcy
  5. insolvency (to the extent you are insolvent)

What Are the Most Common Exclusions for Canceled Debt?

The IRS determines that a taxpayer is insolvent when that taxpayer’s total liabilities surpass his or her total assets. To apply for an insolvency exclusion, you must complete a form that lists all of your assets and liabilities. Have an Oklahoma City tax attorney help you fill out that form.

A canceled debt exclusion is also available for qualified principal residence indebtedness. Your primary home is your “qualified principal residence.” A qualified principal residence exclusion may be available when a lender begins a foreclosure or consents to a short sale.

The IRS partially rolled back this exclusion in 2017, and the IRS only allows it now if the discharged debt was “subject to an arrangement that was entered into . . . in writing before January 1, 2018.”

How Do You Report Forgiven or Written Off Debt?

When a financial institution writes off or forgives $600 or more of a debt’s principal (the part of the debt that does not include fees or interest), it will send you a Form 1099-C when the tax year ends. Be sure to report the written off or forgiven figure on your Form 1099-C as income.

If you do not receive a Form 1099-C, the creditor may have filed one with the IRS. If you don’t include the amount on your tax return, you could receive a tax bill or even an audit notice and owe more – in penalties and interest to the IRS – than you saved through the debt settlement.

The IRS has resolution options for taxpayers with financial problems. You may qualify for a long-term payment plan, a settlement, or a “Currently Not Collectible” status for those suffering financial hardships. Your attorney can determine if you qualify for one of these options.

What Else Should You Know About Debt Settlement and Taxes?

When you negotiate a settlement with creditors, you should hire a debt settlement lawyer rather than a debt settlement company. Debt settlement companies cannot act legally on your behalf, and they often make promises they cannot keep in order to win your business.

However, a debt settlement attorney will review all of your alternatives with you and recommend your best debt relief option.

It is not news that the tax laws and IRS rules are exceedingly complicated. An Oklahoma City tax attorney can help you review your options for dealing with forgiven or written off debt and recommend the best way for you to move forward and to avoid paying any unnecessary taxes.

In Oklahoma, if you are dealing with overwhelming debt, if you are considering bankruptcy, or if you encounter tax difficulties after a creditor forgives or writes off a debt, reach out at once to an Oklahoma debt relief lawyer for the legal guidance, advice, and representation you will need.