Sometimes a creditor will let you off the hook on paying your debt, typically when it gives up trying to collect it from you. When your responsibility is discharged and the debt gets canceled, the Internal Revenue Service usually considers it as income. Since it is income in the eyes of the IRS, a debt discharge is frequently, but not always, taxable.
The creditor may send you and the IRS a 1099-C form, which reports the cancellation of the debt. A good understanding of discharged debts will help you identify and address any errors.
Taxable Discharged Debts
Generally, if a debt gets discharged and one of the exceptions (explained below) doesn’t apply, the discharged amount is taxed as regular income in the year that you receive it. For instance, if a credit card company lets you pay off a $4,000 credit card balance with a $1,500 settlement, the $2,500 discharge is taxable.
Debts Discharged in Bankruptcy
The IRS doesn’t require you to pay taxes on debts that get discharged in bankruptcy. If bankruptcy wipes out debts – whether it’s $600 or $60,000 – you won’t owe taxes on the discharged amount. While bankruptcy can be a way to get out of debt tax-free, it can have serious negative effects, including a negative mark on your credit that shows up whenever you or a creditor performs a credit check on you, for as long as 10 years.
Debt Discharge Drawback
Getting debt discharged might seem like a relatively good deal even after you pay any taxes that are due, but it has an important drawback. Just because your debt goes away doesn’t mean it disappears completely. Your credit report will still reflect your delinquency. The negative information related to your discharge can show up for over seven years from when you first wentdelinquent on the account.
About the Author
Solomon Poretsky has been a writer since 1996, with experience in the fields of financial services, real estate and technology. Poretsky holds a Bachelor of Arts in political science from Columbia University.
This article is provided for general guidance and information. It is not intended as, nor should it be construed to be, legal, financial or other professional advice. Please consult with your attorney or financial advisor to discuss any legal or financial issues involved with credit decisions.
Published by permission from ConsumerInfo.com, Inc., an Experian company. © 2014 ConsumerInfo.com, Inc. All rights reserved.