Setting Aside Funds for Taxes Before Accepting Debt Relief or Settlements
If you are struggling with overwhelming debt, debt relief programs like debt settlement or bankruptcy may seem like attractive options. However, it’s important to understand the potential tax implications of these programs before moving forward. The canceled debt from these programs may end up being taxed as income, leaving you with an unexpected tax bill if you aren’t prepared.
Understanding Canceled Debt and Taxes
When you take out a loan or owe money on a credit card, that money becomes tax-free income to you. You essentially borrowed that money tax-free. However, if that debt is ultimately canceled or forgiven, the IRS often views that canceled debt as taxable income. This is because you originally borrowed that money tax-free, so if you no longer have to pay it back, the IRS wants their share of taxes on it.Some common ways debt can be canceled and potentially trigger a tax bill include:
-- Debt settlement – Negotiating with creditors to pay less than the full amount owed. The amount forgiven is potentially taxable.
- Bankruptcy – Much or all debt eliminated, depending on the type of bankruptcy. Canceled debt is potentially taxable.
- Foreclosure – If the home sells for less than what is owed on the mortgage, the difference can be viewed as canceled debt and taxed as income.
- Repossession – Same concept as foreclosure. If the car sells at auction for less than what is owed, the difference may be viewed as income.
So in many cases, accepting debt relief may solve one problem but create another – a surprisingly high tax bill. Fortunately, there are some ways to avoid or minimize this tax burden if you plan ahead.
Setting Aside Funds in Advance
Before finalizing any debt relief or bankruptcy agreements, experts recommend setting aside funds to cover the expected tax bill. This involves estimating the amount of debt likely to be canceled and multiplying it by your effective tax rate to estimate what tax will be due on that canceled debt.For example, if you expect $50,000 in debt to be forgiven upon the completion of a debt settlement program, and your effective federal tax rate is 22%, you would owe approximately $11,000 in taxes on that canceled debt (50,000 x 0.22). Having this money set aside in advance, rather than being surprised later, can make all the difference.Ideally, you would set up a separate high-yield savings account and automatically transfer a fixed amount each month leading up to your final debt relief. Online banks like Ally Bank typically offer much higher interest rates than brick-and-mortar banks, allowing your money to grow faster. The key is being consistent and disciplined in setting aside what you can afford each month.
Strategically Timing Debt Relief Acceptance
In some cases, there may be strategic timing advantages related to what tax year you actually accept and finalize a debt relief or bankruptcy agreement. This timing can potentially help minimize taxes owed.For example, if you lost your job halfway through 2022 and had little taxable income for the year, accepting a debt settlement agreement in 2022 could be advantageous compared to finalizing it in early 2023 when you are employed again. Less taxable income in 2022 could put you in a lower tax bracket and thus reduce taxes owed on the canceled debt income.A tax professional can help run the numbers and advise you on best timing, but being aware of the concept allows you to minimize taxes owed. Again, this requires planning in advance and having set aside funds before finalizing debt relief agreements.
Special Tax Exclusions
The good news is some canceled debt does qualify for tax relief, meaning it can be excluded from taxable income. Two major examples include:Bankruptcy – Debt discharged through bankruptcy court, where you qualify as insolvent, is not viewed as taxable income. You still have to report it, but will not actually owe tax on it.Principal Residence Debt – Forgiven mortgage debt used to buy, build or substantially improve your principal home does not count as taxable income. This provision has saved many homeowners going through foreclosure.So in cases involving bankruptcy or home foreclosures, be sure to investigate whether you qualify for these special tax exemptions on canceled debt.
-Getting Professional Tax Help
Navigating the complex IRS rules around debt relief and settlements can be frustrating and confusing. Getting personalized guidance from a tax professional is highly recommended before finalizing agreements.A few reasons why tax help is so valuable:
- They can confirm which of your canceled debts will or won’t be taxable.
- They can explore special exemptions and tax code provisions that may apply to your situation.
- They can run the exact numbers to estimate your tax liability, ensuring you set aside sufficient funds.
- They can advise you on the best timing and strategy to minimize taxes owed.
Look for a tax professional who specializes in debt relief issues, such as an Enrolled Agent (EA) or Certified Public Accountant (CPA). This expertise can save you significant money and headaches when dealing with the IRS.
Creating a Financial Safety Net
Setting aside extra savings as a safety net is always wise when pursuing debt relief, given the unpredictability of life events. Having an emergency fund protects you from going deeper into debt if faced with unforeseen expenses like medical bills, car repairs, or temporary job loss.Aim to have 3-6 months of living expenses saved before accepting final debt relief or bankruptcy agreements. This gives you a cushion and cash flow buffer as you rebuild your financial life after debt settlements are completed.The bottom line is debt relief can provide a critical lifeline and fresh start for those burdened with unmanageable debt levels. However, understanding the tax implications in advance and planning accordingly is vital for minimizing headaches down the road. Do your due diligence and get professional tax help to make the process as smooth as possible.
Resources:
How Debt Settlement and Canceled Debt Affects Your TaxesWhat You Need to Know about Taxes on Forgiven DebtSettling Credit Card Debt? Be Aware of the Tax Bite