The 15th of April is here, which means: Tax Day. This is the last day you can file your taxes without having to pay a penalty, so make sure you’ve filed them or (have been granted an extension)! This may be the time, and rightfully so, that you wonder what the tax implications of using any form of debt relief are. Maybe you’re still doubting if you want to make use of a debt relief service, but are unsure about tax implications, which is why you’re postponing taking action. Lucky for you, we are here to tell you all about the tax implications of using any of the most common types of debt relief.
In this blog, we will carefully explain what happens to your total tax burden when you use any of the most common types of debt relief. The types of debt relief we will touch upon are debt settlement, debt consolidation, bankruptcy, and credit counseling. Some of these types of debt relief have pretty clear tax implications, others are not so straightforward.
Yet, what all these types of debt relief do have in common is that they can all help you get rid of your debt and take back control over your financial life. Whatever type of debt relief is the best way forward in your situation, after reading this blog you’ll know exactly how they affect taxes. This helps you to make the choice that’s right for you in your unique situation. Let’s dive in!
The overall tax implications of canceling debt
Generally, if a loan is canceled (or repaid by someone else), the IRS asks you to add the amount that is paid for or canceled to your gross income. Therefore, when a debt is canceled, your gross income increases, which means you have to pay more in income taxes. Although this is generally true, there are some exceptions to this rule (such as filing for bankruptcy), in that the canceled amount does not have to be added to your gross income. It’s good to keep this general rule in mind when reading the rest of this article.
How the most common types of debt relief affect your tax bill
Debt consolidation and its tax implications
Now, let’s go through the most common types of debt relief one by one. First up: debt consolidation. Debt consolidation means that you consolidate multiple smaller debts into one big debt. You’ll request a new loan, which you can use to pay off all smaller debts, leaving you with one big debt to manage. This method of debt relief is powerful if you can get a lower interest rate on the consolidation loan versus the average rate on all smaller outstanding debt.
In most cases, debt consolidation doesn’t lower the total amount you owe. Yet, it makes your monthly payments easier to manage, plus it lowers your interest burden potentially saving you money in the long run. As you see, this type of debt relief doesn’t involve debt cancellation. Therefore, the tax implications of this type of debt relief are quite minimal–your gross taxable income will not increase because of debt consolidation.
The only way debt consolidation might affect your tax burden is by the interest deduction. For example, interest on home equity loans is tax-deductible, while interest on most personal loans is not. If you could get a consolidation loan of which the paid interest is tax-deductible, while the interest on your current outstanding debt is not, this could lower your overall tax burden. This can be a complex game to play, so before going this route it’s always a good idea to consult a debt expert or tax advisor.
The tax implications of debt settlement
Next up: debt settlement. This type of debt relief entails that an expert debt negotiator will get to work for you. That person will negotiate with creditors on your behalf, doing everything in their power to lower the total amount you owe. You might be surprised how well this works–the average creditor is often happy to work with you because they’ll happily take a percentage of the outstanding debt, rather than take the risk of you going bankrupt and settling the debt with a $0 balance.
In many cases, the negotiator will be able to negotiate a good deal with your creditors. This will bring down the total amount you have to repay, saving you both time and money. But, as you probably would have guessed: this could have tax implications. Your gross income will increase by the total amount of debt that is forgiven, over which you need to pay income taxes. Therefore, while you save money by lowering the total amount you have to repay, you will probably have to pay a little more in income taxes. While this might sound scary, in most cases, the additional tax cost is small relative to the savings in terms of debt.
If the canceled debt is $600 or more, the creditor will usually send you a so-called 1099-C Form. This is a form used to report the cancellation of any debt. You will need to report this amount while filing your taxes.
Although most canceled debt has to be reported as ‘income’, there are a few exceptions to this rule. In some cases, you may be able to exclude the amount of canceled debt, especially if you carried this debt in the form of a student loan. Student loan cancellation due to meeting certain work requirements and loans canceled through student loan repayment assistance programs are exempted from this rule. Hence, always check your tax filing twice if you have your student loans canceled. For a full list of exceptions to this rule, please consult a debt expert or check the website of the IRS.
How filing for bankruptcy may change your tax bill
Above, we told you that when debt is canceled you have to report this as an addition to your gross income for tax purposes. However, if your debt is canceled in a Title 11 bankruptcy case (which includes chapters 7, 11, and 13), this canceled debt isn’t seen as addition to your gross taxable income. But be careful, to be exempted from paying taxes over your canceled debt, you must be a debtor under the jurisdiction of the court, as well as that the cancellation of the debt must be granted by the court.
And to add to that, you have to prove to the IRS that your debt was canceled in a bankruptcy case for it to be excluded from your gross income. To do this, you have to attach Form 982 to your federal tax filing and check the box on line 1a.
The two most common types of bankruptcy are Chapter 7 and Chapter 13. In terms of tax implications, what’s also important here is that the bankruptcy trustee can keep your tax refund. With Chapter 7, this will happen only once. But, with Chapter 13, this may happen every year while you are in your repayment plan. Again, it’s always a good strategy to consult with a debt expert or lawyer before filing for bankruptcy, as they can walk you through all possible consequences of your choices regarding bankruptcy.
The (non-existent) tax implications of credit counseling
When it comes to debt relief, the least drastic measure you can take is credit counseling. It’s the least drastic, because it doesn’t change anything to your outstanding debt. Hence, it doesn’t have any tax implications. You’ll meet with a trained counselor to go over all aspects of your finances and pinpoint any problems. They can provide guidance on things like budgeting adjustments, smarter money management techniques, and strategies to pay off your debt. Credit counseling agencies also offer educational materials and workshops to teach important financial skills like how to create a budget, save money, and understand credit.
This can help to reduce the feelings of stress and overwhelm you may feel whenever you think about your debt. With some solid education and a clear budget (that still allows for some wiggle room), you have a high chance of feeling in control over your finances again. And who doesn’t want that?
Make the right call in your unique situation
During tax time, it’s only reasonable that you’re wondering what the tax implications of using one of the four most common types of debt relief are. We want you to have all the information you need, so you can make the right call and take back control of your debt situation. As you’ve seen in this article, some types of debt relief have more severe tax implications than others.
Where the tax implications of getting credit counseling are non-existent, under debt settlement you may need to report all canceled debt as additional gross income. It may feel weird that your tax bill will slightly increase when you settle (part of) your debts, however, in the end it’s highly likely that you will be better off. This is because the amount of savings in debt repayments and interest payments is often way bigger than the increase of your tax bill.
And to add to that, working with a debt expert and creating a solid debt repayment plan is worth a lot in and of itself. Why? Because it has the potential to make you feel in control again–no more stress and overwhelm about your debt anymore, because you know what needs to be done to finally become debt-free.
We hope this article has helped you in understanding what the tax implications of the most common types of debt relief are, but we encourage you to do some more research to get a good handle on what’s best for you. Before making any decisions, you may want to chat with a tax professional or financial advisor to get advice that’s tailored just for you.