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Consumers may achieve relief through a debt settlement program if their debt has grown so enormous that making payments has become difficult, but are concerned about tax consequences on the forgiven debt.

Debt settlement companies assist consumers in reducing their debts by negotiating with either the original lender/card issuer or a collection agency. This allows those in financial trouble to pay off their debts cheaper. Debt settlement experts (typically attorneys) negotiate on behalf of their clients with lenders to persuade them to accept a lump-sum settlement offer that relieves the borrower of unpaid debt in exchange for a fee.

In general, if you have cancellation of debt income because your debt has been canceled, forgiven, or discharged for less than the amount owed, the canceled debt is taxable, and you must report it on your tax return for the year in which it occurred. The canceled debt isn’t taxed if the law specifically allows you to deduct it from gross income.

Leslie H. Tayne, a debt-relief attorney, added, “You will be taxed on any forgiven debt over $600. There are some exceptions, but even if you do end up paying taxes on [the forgiven debt], you’ll generally still be better off than if you had to pay the full sum.”

How Much Does Debt Settlement Cost When Accounting For Potential Tax Consequences?

At Ascend, we believe that debt settlement may be a good option, but it’s only in the context of understanding all of your options and understanding the cost of that option. This is exactly why we built a free debt relief cost comparison calculator so that you are MOST informed. Not even an email address is required, but if you’d like additional insights such as these that estimates tax liability and potential insolvency, we would be happy to provide them.

Here’s an example of a couple of insights of the total all-in cost of debt settlement and savings along with the tax insolvency estimates.

This image shows the estimated tax consequences of debt settlement in a plan
Tax estimates shows how much savings may be reduced.

The insights also help estimate tax insolvency from debt settlement.

Image shows a tax insolvency estimate for debt settlement
Estimate tax solvency by comparing assets and liabilities

What is a 1099-C and who gets one?

According to the IRS, almost every debt you owe that is canceled, forgiven, or dismissed is taxable income to you. A tax form 1099-C, “Cancellation of Loan,” will be sent to you by the lender that forgives the debt. A Form 1099-C is sent when a property is repossessed, foreclosed, returned to a lender, sold, or a loan on your primary residence is modified. If you get a Form 1099-C from a lender, you must usually disclose the amount as taxable income to the IRS. 

Even if you get a Form 1099-C from your lender, you might be able to prevent having tax consequences on debt forgiveness. You are not accountable for taxes on a debt discharged in a Title 11 bankruptcy procedure, such as a Chapter 7 or Chapter 13 bankruptcy.

You can also avoid having tax consequences on a debt if you show the IRS that you were bankrupt when the debt was canceled. Other categories of debt, such as qualified agricultural indebtedness and qualified real estate business indebtedness, can also be withdrawn without being taxed in debt settlement.

The Internal Revenue Service (IRS) provides guidelines and info on 1099-C forms and debt cancellation in particular. 

This is a list of possible codes to look for in Box 6:

  • Bankruptcy (Title 11) – Code A
  • Other judicial debt relief – Code B
  • Statute of limitations or expiration of deficiency period – Code C
  • Foreclosure election – Code D
  • Debt relief from probate or similar proceeding – Code E
  • By agreement – Code F
  • Decision or policy to discontinue collection – Code G
  • Other actual discharge before identifiable event – Code H

How to Avoid Paying Taxes on Debt Settlement

You may be wondering how you may avoid paying taxes on debt settlment.

In rare situations, debts that have been canceled or forgiven might be deducted from your taxable income.

The exceptions to the norm are as follows. Other kinds of debt can be decreased or eliminated, but not entirely. The IRS refers to these debts as exclusions, and they are taken into account before exclusions while filling out tax forms.

As per the IRS, these types of debt forgiveness aren’t taxable in the section below.


The following forms of canceled debts may be allowed to be deducted from taxable income by taxpayers:

  • Bequests and gifts
  • There are a few types of student loans taken by doctors, nurses, and teachers working in low-income or rural locations.
  • Debt that can be written off, such as home mortgage interest (deductible on Schedule A)
  • Value reduced after purchase (e.g., a seller may decrease the value of a property if the owner has debts)


A few types of debt might be reduced. However, they should be filed as exclusion, and the taxpayer should use Form 982. They are as follows:

  • Discharge of debt of the insolvent taxpayer
  • Discharge of debt through bankruptcy
  • The Discharge of qualified farm indebtedness
  • Discharge of qualified real property business indebtedness
  • Discharge of qualified principal residence indebtedness

Work with a licensed tax professional who knows the debt settlement process well and tax consequences while negotiating these exemptions and exclusions.

Understand IRS Tax Consequences If Insolvent

When taxpayers’ overall liabilities outweigh their total assets, they are considered insolvent. Under the “insolvency” exception, the forgiven debt would be removed as income. In most cases, if a taxpayer is insolvent, they are not obligated to consider forgiven debts in income. If the forgiven debt was discharged in a Title 11 bankruptcy action or is qualified farm indebtedness or qualified real property business debts, it may also qualify for the exclusion.

For example, if your total liabilities are $25,000 and the total assets are $18,000 at the moment, you are insolvent in the amount of $7,000. Use the fair market value of your assets instead of what you paid for them or whatever you believe they are worth to estimate their value.

If you’re insolvent, you have two options for explaining it to the IRS.

  • By submitting IRS Form 982, Reduction of Tax Attributes Due to Indebtedness Discharge, or
  • Attaching a thorough letter to your tax return that explains how your total debts and assets were calculated.

How to Estimate Tax Insolvency

Four requirements to determine when estimating insolvency are:

  • The taxpayer;
  • The measurement date;
  • The assets; and
  • The liabilities.

The Taxpayer

In the case of unmarried persons, C corporations, and S corporations, identifying the taxpayer is simple. For various types of companies and married couples, the IRS has published guidelines on determining the taxpayer. Sec. 108(d)(6) states that Sec. 108 is applied at the partner level; thus, a partnership is not the taxpayer. According to Prop. Regs. Sec. 1.108-9, the taxpayer owns unknown entities and grantor trusts.

For the exclusion purpose, married couples are treated as two taxpayers. When one or both spouses have COD income, it is critical to seek legal advice. State legislation governing community vs. non-community property, as well as tax filing status and IRS guidelines, must all be examined.

Measurement Date

Before the obligation is discharged, the taxpayer determines that they are insolvent. This has been read as the day before the discharge date (see Merkel, 109 T.C. 463 (1997), for example). If there are many instances of debt forgiveness, the measuring date is decided independently for each instance unless they are part of a single predetermined agreement (Rev. Rul. 92-53).

Assets and Liabilities

The next stage is to examine the assets and liabilities of the owner/taxpayer. Assets are valued at the FMV of the property (not the cost basis). All of the taxpayer’s debts, along with the debt being discharged, are classified as liabilities. There has been some dispute about which of the taxpayer’s assets and liabilities should be included in the insolvency calculation.

The Internal Revenue Code defines insolvency as the excess of liabilities over the fair market value of assets.

This definition was illustrated in a recent instance.

“Dudley Merkel was a general partner in HMH Partnership. Great Western Bank forgave a $1,439,000 nonrecourse debt of the partnership. Merkel had $359,721 of COD income as a result of the forgiveness. Merkel also was a shareholder in System Leasing Corp. (SLC). He personally guaranteed a bank loan to SLC. The corporation defaulted on the loan. The bank forgave $2,000,000 of the loan on the condition that SLC pays $1,100,000 of it and that Merkel refrains from filing for bankruptcy for 400 days.

Merkel included the $2,000,000 guaranteed debt on his list of liabilities as a contingent liability. As a result, he was insolvent and entitled to exclude the $359,721 of COD income. But the IRS said the guaranteed debt was not part of Merkel’s liabilities, and he was, in fact, solvent, making the COD income taxable. The Tax Court ruled in the IRS’s favor, and Merkel appealed.”


How to Budget for Taxes Consequences in Debt Settlement

While paying off your debt may be a significant relief, you should be aware that you may have tax consequences on the amount of money settled. Your creditor may issue you a 1099-C cancellation of debt tax notice, considering the type of debt. At the end of the tax year, any creditor that forgives or writes off $600 or over of a debt’s principal is required to send you and the IRS a Form 1099-C. President Biden signed the American Rescue Plan into law in March 2021, exempting forgiven student loans from being counted as gross income until December 2025.

Your income is taxed at your regular tax rate, which for 2021 runs from 10% to 37%, depending on your taxable income. The United States has a progressive tax system, which means that the tax rate rises as the taxable base grows.

Budget for tax consequences on forgiven debt

If you opt for a long-term debt settlement program, you wouldn’t have to pay all the forgiven debt at once, and it depends on when the debt is forgiven in the program.

The budgeting options are as follows:

  • Estimate your monthly income, choose a budgeting strategy, and track your success.
  • As a basic budgeting structure, use the 50/30/20 rule.
  • Spend up to 50% of your money on necessities.
  • 30 percent of your money should be set aside for wants.
  • Set aside 20% of your income for retirement and paying down debt.

There is another 25 percent rule, which categorizes your pretax income into four equal parts.

  • 25 percent for taxes –  Save this amount of money from your paycheck for tax payments. If you get a refund, allocate the funds into the other three categories.
  • Save 25 percent for housing – To pay for rent or mortgage.
  • Save 25 percent for debts – A larger portion for paying down debt.
  • 25 percent for living expenses – This amount is used to pay for everything else, including savings.

Is Debt Settlement Still Worth It?

Debt settlement may be a good option for people surviving a debt dilemma. It is worth it if all of your debt is with a single creditor, and you’re able to offer a lump sum of money to settle your debt. Typically, if you can afford fixed monthly payments, then you may easily choose consolidation options for your debt problems. It is preferable to consolidate payday loans with payday loan consolidation method or eliminate credit card bills with the help of credit card consolidation while maintaining your credit score.

You may have to choose a debt settlement alternative if you can’t afford your debt payments. But keep in mind that this strategy has some potential drawbacks; take a look at the following:

You may have to end up paying taxes on debt settlement

If you save more than $600 through debt settlement, you may have tax consequences on that amount saved. So, ultimately, you are saving less than you have expected.

Negotiation issues

The creditor has the option of refusing the settlement offer. As a result, you and the debt settlement firm may need to make a counteroffer. You may also be obliged to approach the original lender to see if a payment plan can be worked out. In the worst-case situation, you could end up owing more than you did before, and a declined settlement offer could force you into bankruptcy.

Increased Debt

Fees paid to a debt settlement agency, as well as costs and interest levied by an original lender, could add hundreds, if not thousands, of dollars to your debt.

Impact on credit score

Creditors may become eager to settle your debts only when they get the assurance that they’ll get paid. If the debts become past due and you need to contact a debt settlement company, your credit score may drop due to debt settlement, and sometimes it may fall more than 100 points. Apart from that, a debt settlement remains on your credit report for at least seven years.

About the Author: Lyle Solomon has considerable litigation experience as well as substantial hands-on knowledge and expertise in legal analysis and writing. Since 2003, he has been a member of the State Bar of California. In 1998, he graduated from the University of the Pacific’s McGeorge School of Law in Sacramento, California, and now serves as a principal attorney for the Oak View Law Group in California. He has contributed to publications such as Entrepreneur, All Business, US Chamber, Finance Magnates, Next Avenue, and many more.

Post Author: Ascend

Group of guest writers and industry experts who have specific expertise in Chapter 13 bankruptcy, Chapter 7 bankruptcy, debt relief, debt settlement, and debt payoff.

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