Debt Settlement Funds
The process of debt settlement occurs when a person in debt and his or her creditors make an agreement on a reduced balance amount that will, from that point onward, be regarded as the total amount due to be paid back. It’s sometimes also known as “debt arbitration” or “debt negotiation.” If you think you may be in need of a debt settlement arrangement, there are a number of options available for you to start the process.
You can contact a debt settlement company directly, hire a lawyer to work on your behalf, or you can work by yourself with your creditors to reach an agreement. Any of these options can be taken if you feel that reaching a debt settlement agreement is the best way to get yourself on the road to financial freedom.
Video: Debt Settlement
Are Debt Settlement Funds Considered Taxable Income?
In a nutshell, yes they are. For those whose debts are partially canceled (also known as “forgiven”), they will need to report the canceled portions to the IRS as taxable income. Because a debt settlement is conducted outside of the bankruptcy system, any amount greater than $600 is considered taxable. To file this with your federal taxes, use Form 1099-C.
There is a notable exception to this, however. If a person was “insolvent” at the time of the forgiven debt, he or she will not be required to report the forgiven amount. To be classified as insolvent, the total amount of a person’s debts must be larger than the sum of his or her assets (i.e., the total money and property owned). The IRS does note that any amount of canceled debt that exceeds the amount for which the person is insolvent cannot be excluded. In other words, if a person is $25,000 in debt but only possesses $5,000 in personal assets, this person cannot exclude more than $20,000 from income tax. Any debt amounts over $20,000 will have to be reported to the IRS as taxable income.
Video: Debt Settlement or Debt Negotiation?
Debt Settlements, Battled Contests, and Bankruptcy
A “battled contest” situation occurs when a person going through the debt settlement process disputes the debt sum attributed to him or her. If this person wins the debt settlement, he or she will then be excluded from the Discharge of Indebtedness Income (DOI) rule. For example, say that your credit card claims that you owe $2,000 to a major department store. You, however, know you did not make any purchases at the store totaling that amount. When you dispute this during the debt settlement process, let’s say you agree to pay the credit card company $200 to reach a settlement.
If you eventually win the debt settlement arrangement because of your dispute, you will not be legally required to report this amount as taxable income. But if you had not won the case via this protest or dispute, you would be held responsible for the DOI Income rule. With regards to declaring bankruptcy, if you have done so and are making only a small percentage of the original debt payments you owe, the remaining amount will be excluded from the DOI Income rule.
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