Did you know that if you settle your credit card debt, you may end up owing taxes?
That’s right. By settling your debt, you may be trading one set of debt for another.
In order to understand how this works, let’s take a simple example. Let’s suppose you have $20,000 in credit card debt.
You get an offer in the mail that says, we’ll accept $8,000 in exchange for full release of the debt. You think to yourself, “this is a great deal!” and mail a check for $8,000.
The bank is required by the IRS to issue a 1099-C for “cancellation of debt.” (See: IRS guideline on 1099-C.) This means, you may owe taxes on the amount that’s forgiven – in this example $12,000. Assuming you’re in the 25% tax bracket, you will owe the IRS $3,000. In addition, you may also owe state income tax as well.
Another common tax trap I see is either borrowing money from retirement accounts or liquidating it to repay debt. Borrowing from your 401(k) may seem like a good idea because you can generally get a better interest rate than your credit card.
Going back to my example, let’s suppose you borrow the $8,000 from your 401(k) to help pay down the $20,000 credit card debt. Then something happens and you can’t repay the money.
Now, you’re looking at a 10% early withdrawal penalty plus income tax in addition to the taxes for the cancellation of debt. The same is true if you liquidate your retirement account.
Unfortunately, most lenders do not warn you about the tax consequences of debt settlement and you may not even be aware of the tax implications until you get the 1099 in the mail. By then, it’s already too late. You can’t undo the debt settlement and you’ll still owe the tax.
One other point worth mentioning is that lenders will also issue 1099-C if you simply default on your debt. So, instead of settling with your lender, if you stop paying them, they will eventually issue a 1099-C. Unfortunately, this does not mean that the banks can’t continue to collect from you; it’s an internal accounting procedure.
There are ways to avoid paying taxes on cancellation of debt including filing bankruptcy or insolvency. Consulting a CPA or tax professional who is familiar with this issue is very important before you write a check to settle your debt. Of course, if you receive an unexpected 1099, you should seek help immediately.
About the Author:
Jeena Cho is a San Francisco attorney with JC Law Group PC. She works with individuals and small businesses in finding solutions to debt problems. Jeena is a published author with LexisNexis. In her spare time, she enjoys cooking and traveling. She lives in the Bay Area with her husband.