Forgiven Credit Card Debt May Be Taxable

Forgiven Credit Card Debt May Be Taxable

July 22, 2020         Written By Tracy Farnsworth

 

Have you ever felt like you’re in over your head? You can’t keep up with your credit card payments and looking for a way out. What if I told you the answer is closer than you think? Your driving in your car, or maybe even riding the bus with these thoughts, and suddenly you hear a radio ad for a debt settlement company who offers to forgive some of your debt. But before you call them and agree to their offer, make sure you’ve read this article to understand your requirements when it comes to yearly income taxes.

When you negotiate a debt settlement for any debt, you may not realize that the amount that’s written off can count as taxable income. Debt that is forgiven may never need to be paid by you, but it’s still money you gained. You owed it, and now you don’t. For that reason, it’s considered income and you’ll need to pay income taxes on it. 

Say you owed $5,000 and couldn’t keep up with the payments so your account goes into default. The debt collection company agrees to forgive $2,000. You just need to pay them $3,000 and the credit card account gets marked paid in full. The IRS looks at that $2,000 as income. You’re usually obligated to claim it as income on your taxes and pay the income taxes on that amount. Very few exceptions exist when it comes to avoiding paying taxes on it.

What Are the IRS’s Exceptions for Forgiven Debt?

Whether or not you owe taxes on the amount of debt that has been canceled depends on a few things. The amount of canceled debt has to have been $600 or more. If the credit card debt was forgiven in a bankruptcy, you may be allowed to exclude the forgiven credit card debt from your total income. The same is true if you were insolvent when the debt was forgiven.

Insolvency is important to understand. Your total assets must be less than the amount of credit card debt you owe. It’s not going to be easy to meet this obligation if you own a car, home, or expensive jewelry. It’s unlikely that you’ll have far more credit card debt than total assets. If you do, however, and you get a 1099-c, you should call the IRS or a tax advisor for help on the next steps to take.

Another way canceled debt is not going to count as income is if they cover mortgages and student debt. Gifts and bequests also count, but it’s unlikely your credit card debt was forgiven for one of those reasons. If you’ve had your credit card debt forgiven outside of a bankruptcy or insolvency, be prepared to pay taxes on that money.

Whether you have to declare it as income or not, you should receive a 1099-C. It has to be mailed by January 31st. Talk to a tax advisor to make sure you’re not misunderstanding any rules before you file. You don’t want to skip declaring that money and have the IRS contact you to inform you that you didn’t file correctly and now owe money or are getting less of a refund.

For more information on the IRS’s exceptions please visit https://www.irs.gov/pub/irs-pdf/p4681.pdf

Preventing an Unexpected Tax Bill When You File Your Taxes

Don’t wait until you get Form 1099-C to find out that you have to declare it as income. Talk to the financial institution or debt collection firm to see if it will be considered income. When you know in advance, you can start planning. If you have to come up with that money when you go to file your taxes, it can be a financial strain. It’s better to know in advance so that you have time to submit estimated tax payments to cover the amount.

Click here for 2020’s Form 1099-C

What is an estimated tax payment? It’s the way to pay off taxes you will owe when you file the next year’s income taxes. Make one payment or divide it up into quarterly payments if there’s time. To do this, look up IRS Publication 15-T and view the tax chart to see what your withholding would be based on your estimated yearly income. The chart lists your usual filing status and different income brackets.

How do you know how much to pay? Add in the amount of your credit card debt settlement to your income. The withholding chart will show a base amount plus a percentage. Make sure the money you pay in estimated taxes covers that amount. Take a recent paycheck stub and see how much in taxes are withheld. Multiply that by 52. Subtract that answer from the amount you came up with on the withholding chart and make sure you submit the difference through estimated tax payments on April 15, June 15, September 15, and/or January 15 or the next business day after those dates if they fall on a weekend or holiday.

Using the earlier example, say you have $2,000 in debt forgiven by the credit card company. Your annual income is around $50,000. On the tax chart, it shows your federal withholding rate is $1,950 plus 12%. You look at your paycheck stub and about $140 is withheld each week. By the end of the year, you will have paid $7,280. When you multiply $52,000 times 12%, it’s $8,190. You’re going to be $910 short. You can avoid having to come up with that extra $910 by paying it off in one or more estimated tax payments. You could make four payments of $250 and have more than enough paid before it’s time to file your taxes.

That takes care of federal taxes. What about your state? Will you owe money there too? Do you also owe income taxes to your state throughout the year? If your state does have an income tax, you’ll be counting that paid off debt as income, so estimated taxes paid to your state will also help.

Don’t Borrow More Than You Can Afford

While credit card debt forgiveness can help you out of a financial tight spot, it’s best not to fall into a debt trap. How do you do that? It’s not something you can rush. Start by making smart purchases and paying your bill on time. If you pay late, you’ll start racking up late payment fees and over-the-limit fees. That alone will increase your debt.

After you apply for a credit card, don’t become tempted to purchase more than you can afford. The computer you see on clearance is a great deal, but can you afford to pay it off at the end of the month? If you make minimum payments, the computer will be worthless and you’ll still be paying it off. Make sure your purchases are smart ones.

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If you do find yourself getting into trouble, cut up the card. Delete it from any online stores that have saved it in your wallet. Stop using it. Increase your payments to as close to double the minimum payment as you can. If you find yourself with $100 extra after your other bills, put that $100 into savings. When you have a few months of income saved up in a savings account, start putting the extra money you have each month towards the credit card you’re trying to pay off. Make weekly instead of monthly payments. Micropayments help reduce the interest that accrues during the month. You’ll save money this way and pay off your debt faster.

Talk to your current credit card company and see if they’re willing to lower your interest rate. Explain your situation and see if they’ll work with you. They’d rather work with you than lose money if you suddenly can’t pay. This is most effective if you have a solid credit history with the company and haven’t paid many or any bills late. It doesn’t hurt to ask. At most, you’ll be told no. At that point, work on other options for getting out of debt.

Have you considered applying for a different credit card and transferring your balance?

A high-interest rate can make it hard to afford payments, especially if the credit card company raised the interest rate unexpectedly. If that happens, research low-APR credit card offers with free balance transfers and see if you can be pre-approved. You can save a lot of money moving to a more favorable credit card offer. Keep making payments in order to get the balance paid down as quickly as you can. If you’re offered a 0% APR or introductory low-interest APR, pay close attention to the expiration date. At that point, the APR will rise drastically, which won’t help you in the long run.

Shop around for the best credit card terms. It’s in your best interest to read credit card reviews, the study offers, and find the best fit. If you apply for real, the hard pull of your credit will place a ding on your credit score. If you pre-qualify, only a soft pull takes place and that won’t impact you. It makes it a lot easier to narrow down your options from 10 credit card companies to your first and second choices before you fill out an application. When you do apply for a new credit card, start with your first choice and go from there.

 

 

 

The information contained within this article was accurate as of July 22, 2020. For up-to-date information on any of the terms, cards or offers mentioned above, visit the issuer's website. Many of the offers on this article are from our affiliate partners, and LowCards.com may be compensated if you take action with any of our affiliate partners.

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tracy

About Tracy Farnsworth

Tracy Farnsworth went straight from a business track in high school to a full-time job in mortgage banking in Burlington, Vermont. After having children, she built a freelance career in content writing and took online classes as time allowed. She completed Social Media Marketing and Digital Marketing certificate programs with Ireland's online Shaw Academy and completed several courses in SEO and analytics. In her free time, she's the “mom” to a very clingy rat terrier, and the pair walk at least a mile every day. She's also a novice baker who is trying to master the art of sourdough bread.