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Strategies to Minimize Taxes on Canceled Debts and Settlements


Strategies to Minimize Taxes on Canceled Debts and Settlements

If you are struggling with overwhelming debt, settling your debts for less than the full amount owed can provide much-needed relief. However, debt settlement can also create an unexpected tax bill if the canceled debt amount exceeds $600. Fortunately, there are strategies to minimize or even eliminate taxes on canceled debts and settlements.

Understanding Cancellation of Debt Income

When a creditor agrees to accept less than the full amount owed in satisfaction of the debt, the amount of debt forgiven is called cancellation of debt (COD) income. Essentially, the IRS considers forgiven debts to be income, as if you received cash.

COD income is taxable unless an exclusion applies. Common exclusions include bankruptcy, insolvency, certain farm debts, non-recourse loans, and debts discharged between spouses or former spouses. If COD income exceeds $600 and no exclusion applies, you must report the forgiven amount as taxable income on your tax return.

Excluding COD Income with Bankruptcy

One way to potentially exclude all COD income from taxes is to file for bankruptcy before settling debts. When debts are discharged through bankruptcy, the canceled amounts are not considered taxable income.

However, timing is important – the bankruptcy discharge must occur before the debt is settled for this exclusion to apply. If you settle a debt first and then file for bankruptcy, the previously settled debt would still be taxable COD income.

Chapter 7 and Chapter 13 bankruptcies can both exclude COD income, but Chapter 7 is faster, eliminating debts completely in a few months. The downside is that you may have to forfeit assets to repay creditors. Chapter 13 takes 3-5 years to complete but allows you to keep assets in exchange for a court-ordered repayment plan.

Using the Insolvency Exclusion

You may be able to exclude COD income by proving you were insolvent at the time the debt was canceled. To qualify as insolvent, your total liabilities exceeded the fair market value of your total assets immediately before the debt cancellation.

The amount of COD income you can exclude is limited to the amount by which you were insolvent. For example, if you settle a $10,000 credit card debt but were only $5,000 insolvent prior to settlement, you can exclude $5,000 of the COD income. The remaining $5,000 canceled debt would still be taxable.

Determining insolvency requires claiming an exclusion on your tax return and maintaining detailed records to prove your assets and liabilities at the time of cancellation.

Structuring Debt Settlements

With proper planning, you may be able to structure debt settlements to avoid cancellation of debt income altogether. Here are some strategies:

  • Settle debts in separate years to take advantage of the annual $600 per creditor exclusion threshold for COD reporting.
  • Negotiate with creditors to “reduce” rather than “forgive” debts. Reduced principal is not COD income.
  • Settle secured debts like mortgages for less than the value of the property. This generates non-taxable mortgage debt relief.
  • Transfer assets or take loans to pay off debts prior to settlement. The cash payout is not COD income.
  • Settle debts for less than reasonable collection potential to exclude income under the disputed debt exclusion.

Claiming Deductions and Credits

If you end up with taxable COD income, look for deductions and credits to help offset the tax impact:

  • Deduct legal fees related to debt cancellation as miscellaneous itemized deductions.
  • Deduct state taxes paid on COD income.
  • Exclude COD income used to fund a retirement account contribution.
  • Claim tax credits like the Earned Income Tax Credit if the COD income increased your adjusted gross income.
  • Use business deductions and carryforward losses to reduce business COD income.

Setting Aside Funds for Taxes

Ideally, set aside funds to pay taxes at the time debts are settled. The IRS allows you to request that creditors withhold income tax on amounts over $600. You can also make quarterly estimated tax payments.

If funds are limited, consider setting up an affordable installment agreement with the IRS to pay off the tax liability over time. You may qualify for an offer in compromise to settle tax debts for less than the full amount.

When to Seek Professional Help

Consulting with a tax professional can help maximize exclusions and ensure proper reporting of any taxable COD income. An experienced tax attorney can advise you on structuring settlements in a tax-efficient manner.

If you are struggling with overwhelming tax debts, a tax lawyer can also help you pursue defenses such as penalty abatement requests and innocent spouse relief. They can represent you in audits, appeals or litigation if the IRS challenges exclusions or deductions claimed for COD income.

While debt settlement provides relief from burdensome payments, don’t let the potential tax consequences derail your progress. With proper planning and advice, you can settle your debts without taking on a new tax burden.

  1. IRS Topic No. 431 – Canceled Debts, Foreclosures, Repossessions, and Abandonments
  2. 26 U.S. Code § 108 – Income from discharge of indebtedness
  3. IRS: Home Foreclosure and Debt Cancellation
  4. IRS Topic No. 458 – Miscellaneous Itemized Deductions
  5. About Form 1099-C, Cancellation of Debt

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