Consumers, who are knee-deep in credit obligations, are turning to debt settlement companies to reduce the amounts they owe. Many creditors are willing to forgive as much as 60 to 70 percent of what debtors owe in order to receive at least part of the money back, because many consumers file bankruptcy when unable to pay their debts. While it may sound like a great deal, debt cancellation has certain tax ramifications for the consumers who choose to take this step.
When a creditor cancels more than $600 in debt, he is required to report it to the IRS and mail the Form 1099-C to the debtor for the year in which the debt was forgiven. Even though consumers never see this money, the IRS considers this the debtor’s income and charges tax on it. Debtors must file this form with their tax returns and pay any applicable tax on it. The IRS keeps a close eye on these forms and will come after those who fail to file the 1099-C forms and pay the tax. While a few hundred dollars may not significantly increase the tax amount due, several thousand dollars definitely will. When considering debt cancellation, a consumer should contact a tax advisor to find out how it will affect his taxes.
Debt cancellation may have other financial ramifications. Creditors may cancel a consumer’s debt and sell it to a collector. As a result, the consumer will have to pay the tax while still owing the debt. As of right now, there are no laws that prohibit creditors from doing so. Consumers may need to contact an attorney to resolve this situation.
Besides the tax consequences, debt cancellation is reported to the credit bureaus and will affect the debtor’s credit for up to seven years. The creditor reports it because the balance is not paid as agreed. In addition to the negative record, the settled accounts, including credit cards, will be closed. This will affect the credit score, because the amount of the available credit will be significantly reduced.
Most consumers are not aware of the debt forgiveness ramifications. Banks generally do not disclose the possible tax consequences when they cancel debts. Debtors need to know that accepting a debt settlement may have a negative affect on their credit and finances.