Settled a debt for less? The forgiven part may be taxable

When a creditor or collector accepts less than you owe and treats the debt as settled, the part it gives up is canceled debt. The IRS's general rule is that canceled debt is taxable income for the year the cancellation happened.

A worked example

The IRS gives this one. You owe $1,000, and the creditor accepts $400 as payment of the whole debt. You have $600 of canceled debt.

Form 1099-C

After it cancels a debt, the creditor may send you Form 1099-C, Cancellation of Debt, with the amount and the date. Box 2 holds the amount, which may include interest and fees as well as principal. Box 6 holds a code for the reason, such as code F for an agreement to settle for less, or code G for a creditor's decision or policy to stop collecting.

• If the form is wrong, contact the creditor.
• If the creditor keeps trying to collect after sending a 1099-C, the IRS says the debt may not have been canceled. Ask the creditor in writing which it is.
• Taxable canceled debt must be reported even if no 1099-C arrives.

When it is not taxable

The IRS lists exceptions and exclusions. For a canceled credit card debt, Publication 4681 points to two:

• Bankruptcy. Debt canceled in a bankruptcy case is excluded.
• Insolvency. Canceled debt can be excluded to the extent you were insolvent immediately before the cancellation, meaning your total debts were more than the fair market value of everything you owned. Retirement accounts and other assets creditors cannot reach still count as assets in that test. Publication 4681 has an insolvency worksheet.

An exclusion is claimed on Form 982, attached to the return, and it can reduce certain tax attributes, such as carryovers or the basis of property you own. Other exceptions, such as certain student loan discharges, have their own conditions and dates, which Publication 4681 lists.

Before you settle

• The CFPB warns that debt settlement companies often charge high fees, may tell you to stop paying your bills, and can leave you deeper in debt than when you started. You can negotiate with a creditor or collector yourself.
• The CFPB also warns that forgiven debt could be counted as taxable income, and suggests a tax advisor for your own numbers.
• Get the terms in writing before you pay, including that the payment settles the entire debt (see pay for delete).

On your credit report

The CFPB says a collection paid in full, or settled for less, should generally show a zero balance. It can still be reported for the seven-year period that began with the original delinquency (see collections on your credit report).