How Debt Settlement Works

Debt settlement involves negotiating with your creditors to accept less than what you owe. This can be done directly with creditors or through a debt settlement company. While creditors prefer full repayment, they may agree to a settlement to avoid sending your debt to collections or to help you avoid bankruptcy.

Working with a debt settlement company can be risky. These companies negotiate on your behalf but may use tactics that damage your credit. Additionally, you will owe fees to the debt settlement company, and any reduction in your debt is considered income by the IRS.

What Are the Tax Implications of Debt Settlement?

The IRS treats canceled or forgiven debt as income, similar to wages or interest earned. For example, if you settle $5,000 in credit card debt for $1,500, the IRS considers the $3,500 forgiven as income.

If a creditor forgives $600 or more in debt, they will issue a Form 1099-C, which is sent to both you and the IRS. You must report this canceled debt on your tax return. Failure to do so may result in the IRS contacting you about the discrepancy.

How Much Is Settled Debt Taxed?

Settled debt is taxed as ordinary income. The amount you pay depends on your tax bracket and marginal tax rate. For instance, if you earn $75,000 a year as a single taxpayer, your top marginal tax rate is 22%, so any additional income from settled debt will be taxed at 22%.

How Do I Know if I Owe Taxes From Debt Settlement?

Keep records of any settled debt to calculate how much debt was canceled for tax purposes. Match your calculations against the canceled debt reported on any 1099-C forms issued by your creditors.

If you had less than $600 forgiven, you might not receive a 1099-C, but you should still report the canceled debt on your tax return as it is considered taxable.

Exceptions to Canceled Debt

The IRS provides exceptions for certain canceled debts, which are not considered taxable. These include:

• Debts canceled as gifts, bequests, or inheritances
• Qualified student loans with cancellation provisions based on employment in certain professions
• Some student loan discharges made between December 31, 2020, and January 1, 2026
• Amounts received or forgiven under certain student loan repayment assistance programs
• Qualified purchase price reductions given by the seller of property to a buyer

Excludable Debts

The following settled debts do not need to be included in your taxable income:

• Debt canceled in a Title 11 bankruptcy case
• Debt canceled due to insolvency
• Qualified farm indebtedness
• Qualified real property business indebtedness
• Qualified principal residence indebtedness discharged before January 1, 2026

The Bottom Line

While accounting for settled debt on your tax return is straightforward, it is wise to consider your tax bill early in the debt settlement process. If finances are tight, paying taxes on settled debt might be challenging.

Estimate your canceled debt and potential tax liability based on your tax bracket and marginal tax rate. If you need assistance, consult a tax professional to help with calculations and planning. If you cannot afford your tax bill, you may apply for tax debt relief or arrange a payment plan with the IRS.

Debt settlement can impact your credit score. Checking your credit score for free with Experian can help you understand the effects and consider ways to rebuild your credit over time.

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