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If you have outstanding debts, you may be able to negotiate payment with your creditors to settle the debt for less than you owe. Creditors can be amenable to debt settlement because it means they’ll receive at least partial payment. Although debt settlement can save you money, you might end up owing taxes on the forgiven debt depending on the type of debt it was. Fortunately, there are strategies to help you reduce your tax burden for the year.
Key Takeaways
- You can reduce your debt burden by settling debt with a creditor, but you might be required to count the canceled debt as personal income for the year.
- There are a variety of ways in which forgiven debt can be excluded from taxable income.
- Debt settlement stays on your credit reports for up to seven years.
- Before considering debt settlement, research other options that won’t affect your taxable income, like credit counseling or debt consolidation.
Strategies to Minimize Tax Liability on Debt Settlement
If you’re planning on settling a significant amount of debt, you may owe more in taxes than usual, especially if the discharged amount pushes you into a higher tax bracket. Luckily, there are a few things you could try before resorting to debt settlement (and a higher tax bill).
Insolvency
To be insolvent means to have more debts than assets. This means you would be unable to pay off your debt.
Individuals who claim insolvency can have their canceled debt excluded from their taxes by filling out Form 982. Specifically, the amount by which you’re insolvent is the amount that’s excluded.
Example
If you are insolvent by $5,000 and have $10,000 worth of credit card debt canceled, only $5,000 (the amount of your insolvency) is excluded from your taxable income. So, your taxable income would go up by $5,000.
Bankruptcy
Filing for bankruptcy is an option if your creditors aren’t willing to negotiate a debt settlement or you have so much debt you won’t be able to negotiate a deal. Bankruptcy can also be a wiser choice than debt settlement because your entire debt may be forgiven, rather than part; if you use a debt settlement company, you’ll be charged hefty fees as well.
Individuals usually file Chapter 7 bankruptcy , in which your assets are sold to pay your creditors, or Chapter 13, in which you work with a court-appointed trustee to follow a repayment plan for several years.
Debt canceled through Chapter 7 and Chapter 13 bankruptcy (along with Chapter 11) is excluded from personal income.
Credit Counseling
Instead of going the debt settlement route, you might benefit from credit counseling. People struggling with their personal finances can work with a credit counselor, who can negotiate lower interest rates with creditors on their behalf.
The counselor can develop a personalized financial plan to help you work your way out of debt or reach other financial goals. Many credit counseling groups are not-for-profit.
Debt Consolidation/Refinance Loan
If you’ve got a solid income and a good credit score, taking out a debt consolidation loan is a less drastic option than filing bankruptcy or getting hit with a higher tax bill. You may be able to consolidate multiple debts and refinance at a lower interest rate, saving you money overall. But if you’re struggling to pay back overwhelming debt, this option may not be viable because you’d need to take out a large loan and a small reduction in your monthly payment amount may not be enough to provide relief.
Reporting Settled Debts
Debt settlement can provide immediate relief, but you are typically on the hook for the amount that was canceled. The IRS requires you to report the canceled debt as income if $600 or more was canceled. Once your debt is settled, your creditor should send you a Form 1099-C, Cancellation of Debt, and report it to the IRS before tax season begins.
The form shows detailed information like the date the debt was settled, the amount of debt that was settled, a description of the debt, and whether or not you were personally liable.
If you settled less than $600, you don’t have to fill out Form 1099-C, but you’ll still need to report the canceled amount on your Form 1040 under additional income and adjustments to income. This helps the IRS get an accurate picture of your income and debts for the year.
Tax Consequences of Debt Settlement
The IRS requires information about the canceled debt because it treats the amount as income that you owe taxes on. Even though the canceled debt isn’t income in the traditional sense, it is taxed at the same rate as your ordinary income. For 2025, the tax brackets range from 10% to 37%, based on your total taxable income.
To calculate the taxes you owe, follow these simplified steps:
- Add up the total amount of debt canceled. You can keep tabs of this yourself or add up all the amounts on all the 1099-Cs you get.
- List the total amount on line 8c of the Schedule 1: Adjustments to Income and Additional Income form.
- Enter your total Schedule 1 income on line 8 of Form 1040 on your federal tax return.
Tax Exceptions and Exemptions for Canceled Debts
Before you assume your canceled debt is going to be counted as income, check to see if it qualifies as an exception or is exempt.
Exceptions:
- Debt canceled as a gift, bequest, or inheritance
- Student loan debt forgiven as part of a forgiveness program or discharged between Dec. 31, 2020, and Jan. 1, 2026
- Debt that normally would be deductible if paid as a cash basis taxpayer
- Purchase price reductions given by a property seller
Exclusions from gross income:
- Bankruptcy debt, including Chapter 7, Chapter 11, and Chapter 13
- Insolvency
- Qualified farm indebtedness
- Qualified real property business indebtedness
- Qualified principal residence indebtedness discharged before Jan. 1, 2026
Seeking Professional Tax Advice
It can be a challenge to estimate how debt settlement will impact your taxes for the year. Specifically, you may want reassurance about what is and isn’t taxable debt before you decide on a course of action.
To help you chart a financial path, it’s a good idea to get professional financial or tax advice. If you don’t already have a financial counselor, search for one through the Financial Counseling Association of America or the National Foundation for Credit Counseling. Many organizations offer free consultations and free programs.
Frequently Asked Questions (FAQs)
How Does Debt Settlement Affect Your Credit?
Although debt settlement will affect your tax bill for a single year, debt settlement can stay on your credit reports and affect your credit score for up to seven years.
Can Debt Settlement Result in Taxable Income?
Yes, unless the type of debt you settled is excluded from federal taxes, canceled debt through debt settlement is counted and taxable as income for that year.
What Is Form 982?
You can fill out this IRS Form 982 to see if your canceled debt is eligible for exclusion from your taxable income.
What Is Form 1099-C for Cancellation of Debt?
If your creditors canceled $600 or more in debt, you and the IRS should receive a Form 1099-C showing the exact amount that was canceled.
When Should I Seek Professional Tax Advice for Debt Settlement?
There’s never a bad time to get professional financial advice about settling your debt. If you have the option, consider getting advice when you suspect your debt might get overwhelming soon, rather than after. An experienced accountant or tax professional could suggest viable options that allow you to avoid a higher tax bill.
The Bottom Line
If you have the means to pay off a significant portion of your debt, working with creditors to settle your debt with a lump sum payment can be a smart move. However, before choosing this option, consider working with a credit counselor or tax professional to see if it’s the best financial move for you. A financial advisor can go over your finances in detail and may suggest options that can help you avoid paying taxes on debt settlement.
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