You do NOT owe income tax after settling collections if you were INSOLVENT

Please check my 3/7/13 posting on 1099-Cs for important updates!

I’m currently working with a client who is considering settling debts and concerned with having to pay income tax as his accounts are still owned by the original creditors.  So I did some research and I just reviewed the current rules.

As always, I’m NOT an attorney or CPA — please read the IRS instructions yourself and/or retain competent professionals if you can locate any and have the resources to pay them.

You may have to pay income tax on “discounts” received when settling debts as the law requires creditors to report to the IRS debt cancellations of $600 or more.


You owe $10,000 and you settle for $3,000.

If the entire balance was for PRINCIPAL, you would have to pay income tax on the $7,000 discount — if you are not “insolvent.”

Due to the depressed housing market, MANY people who would never consider themselves “insolvent” in fact ARE insolvent for tax purposes.

It simply means that your liabilities exceed your assets and it has NOTHING to do with having too much money in the bank or in retirement funds or having a well paying job. 

It just means that you owe more than your property is worth if you tried to sell it.

Keep in mind that the value of your property is NOT what you paid for it, but what you would RECEIVE if you tried to sell it.

I’m NOT trying to encourage anyone to settle debts, but for SOME people it is the right thing to do if settlement will actually increase their FICO scores and/or they need good credit, such as people with security clearances.

Don’t pay more taxes than you legally owe.

Here are some relevant links:Publication 4681 Canceled Debts, Foreclosures, Repossessions and Abandonment
(for Individuals)

For Individuals and preparation of 2009 returns


Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation.  You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation.  For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include:

  • The entire amount of recourse debt
  • The amount of non recourse debt that is not in excess of the FMV of the property that is security for the debt, and
  • The amount of non recourse debt in excess of the FMV of the property subject to the non recourse debt to the extent non recourse debt in excess of the FMV of the property subject to the debt is forgiven.

It sounds complicated, but the actual IRS WORKSHEET included with the IRS Pub. makes it easy to see how it works: IRS-Insolvency-p4681-opt

If you already filed your tax return and you paid tax on forgiven debt because you received 1099s, make sure that the 1099s ONLY were for forgiven PRINCIPAL (not interest and fees) and that you were NOT insolvent.

You have three years to amend tax returns and to claim insolvency if it applied to your situation.

DEBT  BUYERS should NOT send 1099s.

Debt buyers generally do not have the records to determine how much of the debt is principal and not interest or fees.  Providing a 1099 for an amount including interest or fees should be an FDCPA violation.

More information and case law are at the CreditFactors knowledgebase.

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