Do you get a tax bill after debt resolution?

Every debt problem has at least one solution, so don’t get discouraged. And every potential path to debt freedom has positives and negatives, so it’s smart to do your research. As part of it, consider the possible tax consequences of debt resolution versus other strategies. 

Spoiler alert: Not everyone pays taxes on forgiven debt (but some folks do). Let’s explore the connection between taxes and debt resolution.

What is debt resolution and why is it taxable?

Debt resolution is getting rid of a debt for less than the full amount you owe. The way debt resolution works is that once you pay the agreed amount, your creditor agrees to forgive the rest and close out the debt.  

The IRS considers forgiven debt to be taxable income. That makes sense in a way, because forgiven debt has the same impact on your bottom line as additional income.

If you earn $40,000 this year and a creditor forgives $5,000 in debt, you effectively received $45,000 this year.

At least, that’s how the IRS sees it. And naturally, they want their cut. This can impact which debt solution you choose, because not all forms of debt forgiveness are taxable. 

Debt resolution isn’t always taxable. But sometimes it is, and you’ll want to know that before you crunch the numbers and compare debt solutions like debt resolution or bankruptcy.

When is debt forgiveness tax-free? 

Debts that are discharged (forgiven) in bankruptcy aren't usually taxed. Yes, forgiven debt is still technically income, but the IRS gives people who discharge debt in bankruptcy a break. 

Bankruptcy filers have to submit financial information to a court for review and do whatever the bankruptcy judge says. The bankruptcy process ensures that consumers who file bankruptcy pay their creditors as much as they can afford. Saddling these people with additional costs when they’ve paid everything they’re supposed to defeats the purpose of bankruptcy.

Similarly, some people who go through debt resolution could also get a break on their taxes. 

If you are insolvent, you could get tax-free debt forgiveness without going through bankruptcy. 

Insolvency means that your total debts (what you owe) exceed your total assets (what you own). In other words, if you sold everything you own, you couldn’t get enough money to clear your debts. 

How do you know if you have to pay taxes on canceled debt? 

The IRS provides a worksheet to help you determine whether you’re insolvent. To apply for this tax break, you would need to show the IRS that you’re insolvent by submitting IRS Form 982 with your annual tax return. You could work through the calculations using an Insolvency Determination Worksheet and the fair market value of your assets. If the total debt exceeds the total assets, you could be insolvent. 

Note that we aren’t tax pros and can’t advise you on your specific tax situation. The forms and instructions are available online for anyone to access. Consult a tax professional who can help you make sure your worksheet is complete and correct. 

Complete that worksheet before you decide on a debt solution. The results help you know whether you could qualify for tax-free debt forgiveness without filing bankruptcy. 

Here’s a sample calculation for a woman we’ll call Christine:

Because her debts are larger than her assets, the IRS could consider Christine insolvent.

It’s smart to document these things. You can show your debt balances by providing a copy of your credit report (if all debts are listed), or your most recent account statements. 

You could show the value of your assets with insurance paperwork, printouts from online real estate valuation services like Zillow, professional appraisals of art, jewelry, collectibles, and real estate, printouts from vehicle valuation sites like Kelley Blue Book, and bank, investment, and retirement account statements. 

To be clear, you don’t have to send the worksheet or supporting documents to the IRS—just the Form 982. But the IRS recommends that you hold onto records that could back up your tax return in case you’re audited in the future.

Avoiding debt resolution taxes when you’re insolvent

It’s not enough to determine that you’re insolvent. You also need to know exactly how insolvent you are. It’s possible to be taxed on a portion of your forgiven debt.

Christine is $8,000 insolvent. If she receives more than that amount of debt forgiveness, she might owe income taxes on the forgiven debt above the first $8,000.

Example of tax-free debt resolution

Don is overwhelmed by debt he can’t afford to repay. He’d prefer to avoid bankruptcy because he’d probably have to give up a collectible car that his grandfather left him. It has a lot of sentimental value. Don wants to try to resolve his debts if it makes sense. 

Don owes just over $30,000 in credit card debt. A debt expert advises him that he may be able to negotiate the debt down to $15,000, and Don wants to calculate the potential tax consequences.

Don’s assets include:

• His grandfather’s vehicle, which is worth $10,000

• $2,000 in the bank

• Another car worth about $3,000 

Don has $15,000 in assets. He has no debts other than the $30,000 in credit card balances. 

His insolvency equals $15,000 (his debts are $15,000 greater than his assets). 

If Don’s creditors forgive half of his $30,000 debt, he won’t owe debt forgiveness taxes because the amount of debt forgiveness ($15,000) doesn’t exceed the amount of insolvency (also $15,000). 

What’s next?

If you’re considering debt resolution, the tax situation could impact your potential savings. 

• Look up the IRS Insolvency Determination Worksheet online.

• Get the information you need to complete the form (debt balances and asset values).

Complete the form or contact a debt expert for a free analysis.