One of the most questioned topics at Credit Monkey seminars is  forgiven debt.

I preface every discussion about negotiated settlements of debt with a warning. Be prepared to pay tax on negotiated forgiven debt. According to the Internal Revenue Service, forgiven debt is realized income. That means every penny you saved by negotiating with a creditor is like a penny earned from an employer. Believe it or not, you may need to pay income tax on those “earnings”.

The IRS requires collection agencies to provide a Form 1099 for any forgiven debt of $600.00 or more. If you feel better, think of the 1099 as a trophy for your great negotiation skills and the few pennies paid in taxes as the cost of credit repair.  OK, maybe it doesn’t help, but I tried.

It May Not Be As Bad As It Sounds

Getting taxed for the hard work of digging yourself out of debt seems cruel. However, it may not be as bad as it first appears. Even though the law requires forgiven debt to be taxed, not every forgiven debt is actually taxed.

If a debt was discharged in bankruptcy, no tax should be paid on that debt. Discharged debt and forgiven debt are two different things. Discharged debt is determined and forgiven by the Court. Forgiven debt is negotiated between the parties.

Also, if you are insolvent, the tax on forgiven debt will be waived. Wikipedia defines “Insolvency” as the state of being unable to pay the money owed, by a person or company, on time; those in a state of insolvency are said to be insolvent. In other words, if you are struggling to pay your bills and the only way you could pay the debt was to negotiate a lower payment, you are probably insolvent. One of the few benefits of being broke is that you pay less tax.

There are a few other narrow exceptions to the Forgiveness of Debt Rule.  Discuss your circumstances with a Certified Public Accountant (CPA) and not a tax preparer. A tax preparer fills-in the forms. A CPA knows the rules and will keep you out of trouble with the IRS.

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