What are the tax consequences of settling debt?
Debt settlement clients seldom pay tax on the amount of debt reduced through a settlement program. The general rule is that the forgiveness of debt creates income. Therefore, creditors may report debt reductions to the Internal Revenue Service. However, tax is only paid on forgiven debt to the extent that an individual is solvent. Individuals are only solvent if their assets exceed their liabilities. Most debt settlement clients have debt far in excess of their assets so they pay no additional tax. Form 982 is attached to an individual’s tax return to report insolvency and avoid tax. If a debt settlement client is solvent, tax may be due on all or part of the forgiveness. However, it is better to settle debt and pay the tax. For example, a solvent client in the 25 percent tax bracket receiving a $1,000 debt reduction will pay an additional $250 in tax. Since debt is reduced by $1,000, the client still saves $750.
