Tax Implications of Settling Your Debt

Quick Answer

The IRS taxes settled or forgiven debts as ordinary income. If you’re considering debt settlement or loan forgiveness, try to estimate your tax liability as early as possible so you can see whether exclusions or exceptions can save you on taxes—and plan for an additional tax bill if you have one coming.

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Do you pay taxes on settled debt? It's a question more people may be asking as credit card balances continue to grow. According to the Federal Reserve Bank of New York, credit card balances increased to $1.08 trillion in the third quarter of 2023, and delinquencies are on the rise. As credit card balances become increasingly difficult to pay down, people may turn to debt settlement for relief.

If you've settled debt—with the help of a debt settlement company or on your own—you'll owe federal taxes on the amount of debt that was canceled or forgiven. A few exceptions and exclusions from the IRS apply. Read on for more about how to pay taxes on settled debt.

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How Debt Settlement Works

Debt settlement means getting your creditors to accept less in payment than what you owe. You might be able to work with your creditors directly to hammer out an arrangement. Although creditors would prefer to be repaid in full, they may be willing to negotiate with you if it means they can avoid sending your debt to collections or help you steer clear of bankruptcy.

You can also work with a debt settlement company that will negotiate with creditors on your behalf. Debt settlement is risky, however: Some debt relief companies may use tactics that damage your credit. In addition to paying fees to the debt settlement company for negotiating your deal and administering your account, any reduction in the amount you owe your creditors is likely to be considered income by the IRS.

What Are the Tax Implications of Debt Settlement?

The IRS considers canceled or forgiven debt to be income, the same as your wages or interest earned on your bank account. If, for example, you settled $5,000 in credit card debt for $1,500, the IRS would count the $3,500 in debt forgiveness as part of your income.

If a creditor forgives $600 or more in debt, they'll issue a Form 1099-C showing the amount of debt they canceled. The 1099-C is mailed to both you and the IRS, so you'll need to report the canceled debt shown on your 1099-C on your tax return. If you don't, the IRS may contact you about the discrepancy.

You'll report the canceled debt amount on your federal tax return using Schedule 1: Adjustments to Income and Additional Income. Enter the total amount of canceled debt for the tax year on line 8c, then report your total Schedule 1 income on line 8 ("other income") of your federal tax return, Form 1040. You'll add your canceled debt amount to your wages, interest earnings and other taxable income.

How Much Is Settled Debt Taxed?

Settled debt is taxed as ordinary income. The amount you'll pay is based on your tax bracket and marginal tax rate. Say you earn $75,000 a year as a single taxpayer. Your top marginal tax rate is 22%, so any additional income from a settled debt will be taxed at 22%.

How Do I Know if I Owe Taxes From Debt Settlement?

Keep records from any settled debt to help you calculate how much debt you had canceled for tax time. Match your calculations against the canceled debt reported on any 1099-C forms issued by your creditor or creditors.

If you had a debt of less than $600 forgiven, you may not receive a 1099-C. You should report the canceled debt on your tax return anyway; any canceled debt is considered taxable.

Exceptions to Canceled Debt

The IRS makes exceptions for some canceled debts. If any of the following scenarios apply to you, your debt forgiveness is not considered a taxable debt cancellation.

  • Debts that were canceled as gifts, bequests or inheritances
  • Qualified student loans with loan cancellation provisions based on length of employment in certain professions for a broad class of employers
  • Some student loan discharges made between December 31, 2020, and January 1, 2026
  • Amounts received or forgiven under certain student loan repayment assistance programs
  • Amounts of canceled debt that would be deductible if you had paid them as a cash basis taxpayer
  • A qualified purchase price reduction given by the seller of property to a buyer

Excludable Debts

The following settled debts don't have to be included in your taxable income, even though the IRS considers them canceled debts:

  • Debt canceled in a Title 11 bankruptcy case
  • Debt canceled due to insolvency
  • Qualified farm indebtedness
  • Qualified real property business indebtedness
  • Qualified principal residence indebtedness that is discharged before January 1, 2026

The Bottom Line

Although it's easy enough to account for settled debt on your tax return (and pay the resulting taxes), it may be better still to consider your tax bill early in the debt settlement process, preferably before you sign an agreement. Seeking out a debt settlement arrangement is usually a sign that finances are tight. If meeting your debt obligations is difficult, paying taxes on settled debt might be too.

You can estimate how much canceled debt you've accumulated—and how much tax you might owe—based on your 2024 tax bracket and marginal tax rate. If you need help puzzling this out, you may want to meet with a tax professional who can help you do the calculations and start planning for any additional taxes now. If you can't afford to pay your tax bill, you may be able to apply for tax debt relief, or arrange a payment plan with the IRS.

If you've recently settled debt, you may also want to check on your credit. Debt settlement can affect your credit, and often for the worse. Checking your credit score for free with Experian can help you note the effects on your credit and consider ways to rebuild your credit over time.