Okay, on another post I think that there was some confusion or fear about having to claim money saved from debt settlement as income earned on your taxes. I would like to clarify and also reiterate some things about that.
Debt settlement is a much better solution for a great majority of us. We all know that here. What isnâ€™t commonly known is that creditors are required to report forgiven debts greater than $600 to the IRS on form 1099. This notifies the IRS that you have settled your debt for less than full balance. Hereâ€™s the thing: the IRS views this cancelled debt as taxable income and wants you to pay taxes on it.
Donâ€™t freak out though - there is a bright light in this dark tunnel for MANY of us that see debt settlement as the best or only way out.
The truth is that many of us who choose to go the debt settlement route are NOT liable for taxes on the forgiven debt. The IRS gives an out for debtors who are â€œinsolventâ€ at the time of debt settlement. The term "insolvent" does NOT...I repeat NOT only apply to people filing bankruptcy!!!
The term â€œinsolventâ€ simply means that your debts exceed the value of your assets. If you are in a situation where a debt settlement is necessary, you are probably insolvent. In other words, you would have a negative net worth where your liabilities outweigh your assets.
So How Do you figure out if you are insolvent?
At the end of the year, youâ€™ll get a 1099-C from the creditor with which you settled. The 1099-C will usually have a DATE that your debt was cancelled, and it should match your records with the time you settled and actually paid your creditor.
This cancellation date is important because thatâ€™s the point of reference to determine your solvency. List all your assets and liabilities(debts) AS THEY STOOD ON THAT DATE. Use market value of your house and cars to determine their value as an asset. To determine your home's value you can use a site like zillow or some of the other ones that give free desktop appraisals simply by typing in your address. They include comparable values (surrounding home sales) so the estimate should be pretty accurate. There are also great sites out there to help determine the value of any cars that you own free and clear.
If your debts exceed your assets for that date in time, and the amount you are insolvent to exceeds the cancelled debt amount, then you can declare yourself â€œinsolventâ€ for that settlement. If you settled more than 1 debt, you must repeat this process for each cancelled debt.
To let the IRS know about your insolvency, you must fill out IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness. You would then attach this to your 1040.
If you determined that you were insolvent on your debt cancellation date, then you need to attach some documentation. According to the IRS phone support rep, a simple spreadsheet showing your assets and liabilities like this will suffice:
List of Assets and Liabilities
1099-C Creditor: American Express
Cancellation date: 03/27/2008
Debtor: Joe Schmoe
Tax Year: 2008
Loan Balance: 7890
Amount cancelled: 5623
Car 1: 5,400
Car 2: 3,200
Savings acct: 0
Household items: 2,200
Total assets: 161,164
Credit card debt: 46,000
Total liabilites: 174,200
174,200 in Liabilites
-161,164 in Assets
= 13,036 INSOLVENT
I was insolvent to the amount of $13,036 on 3/27/2008, which exceeded the cancelled debt of $5623, therefore, I am not including the amount reported on the 1099-C on my tax return.
You should do this for each cancelled debt for which a settlement occured in the given tax year.
If you determine that you would not be considered insolvent, keep in mind that the amount you settled on added to the taxes you will owe is STILL much less than what you would have paid to the creditor in the long run. Especially if you had gone on paying minimum payments! Chances are that the interest alone on the payments you would have made far exceed the amount of taxes assessed.
Either way, you save money, eliminate your debt and get to sleep at night. You still won by settling your debt.
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