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Did you get your credit card lender to agree to reduce your debt to settle it in full? That's great - you just saved a bundle of money! Before you get too excited though, you may want to realize the ramifications of your savings. This is what most would consider the "catch."
The IRS might come in between you and your victory vacation because of the taxes you'll have to pay on your settlements. Understand what may be to come, and you'll have a more realistic look at the money you have saved. Here is an overview of how your credit card debt may impact your taxes.
Debt Settlement May Be Taxable
If you were lucky enough to successfully negotiate a debt settlement with your credit card company, you may not be completely out of the woods yet. When loan balances are waived or forgiven, the borrowers or credit card customers are technically still liable for taxes on the amount that was forgiven. In the eyes of the IRS, that money is considered ordinary income. Yes, your forgiven debt – even if it is just built up interest – is considered income.
Do You Have to Pay?
The lender should send you an IRS form 1099-C that shows the amount of the forgiven balance, and then you can use that to file your tax return. However, many lenders forget to mail out these documents. If you suspect that you owe the tax, then you should contact the lender and request your 1099-C. The IRS will not let you off the hook just because you tell the taxman that you didn't know about the regulation or didn't get the document from your lender. You'll still have to pay no matter what. Acting naïve just leaves you vulnerable to any applicable late fees and penalties added to your tax bill.
Note that the IRS is not interested in debt waivers that are less than $600. If you only negotiated a small amount of credit card settlement, then you may be except from this rule. If you discharged the debt through an official bankruptcy, that kind of eliminated obligation is also not subject to this IRS rule. You don't have to worry about paying taxes on those discharged debts.
Reducing Your Debt
Most people cannot get credit card companies to settle their debt for less than is owed. Most companies will only do this if you are underwater and they believe you are on the verge of filing bankruptcy. However, there are other methods that can help you to reduce your debt and potentially avoid taxation entirely. Consider these tips:
- Use a balance transfer to a credit card with an introductory offer of zero percent for a term. This will give you the ability to pay down your debt during that time without incurring interest charges. The Citi Simplicity Card is a good example. It offers a zero percent APR for 21 months on balance transfer.
- Find out what it will take to pay off your debt. Once you discover the right combination of monthly payments, you will be able to create a plan to pay off the debt for good. You can use a debt calculator to help you to do that.
- Combine all of your debts to a low interest credit card. This may help you get rid of some of the heftier interest rates you're currently paying, putting more of your money towards the principle. Just watch out for balance transfer fees as those can increase your overall debt.
Individuals may not be able to avoid paying taxes on any forgiven debt, but most people won't be affected by this rule. Lenders are not likely to forgive most debt without just cause. Work to reduce your debt in other ways and you'll find the IRS isn't holding you back.
*Editorial Note: This content is not provided by Citibank. Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by Citibank.
*The content in this article is accurate at the publishing date, and may be subject to changes per the card issuer.