Tax Machine Blog™

Tax Consequences of Settling Credit Card Debt

1099-C Cancellation of Debt

 

 

So, you’ve got some credit card debt, and you’re not sure what to do. Should you call up you bank and try to negotiate a settlement? Should you declare bankruptcy? Well, before you make that decision, it’s important to consider the tax consequences of negotiating a settlement of your credit card debt. One thing is certain. If your bank agrees to take less than what you owe them, you will be getting a 1099-C.

When people are faced with a credit card bill they cannot pay, they might take several different approaches. Some might decide to ignore the bill for a few months, and simply stop making payments.  The proponents of this approach will argue that a bank is not likely to agree to take less than what you owe if you are still exhibiting an ability to pay. This can cause damage to your credit score, and increase the cost of borrowing in general. But perhaps it will get you what you want in the end – an offer from the bank to settle that debt once and for all, and move on.

There is a catch, however. First, your credit score will suffer and second, the bank will report this discharge to the IRS on form 1099-C. Another thing to consider is how do you plan on paying that lump-sum? If you plan to draw down on your retirement accounts to do so, you will face additional tax consequences, in the form of a penalty for early withdrawal, as well as the tax on previously untaxed amounts that you are withdrawing. You will get one of these when you take a distribution from your IRS or 401k:

 

1099-R

 

So – you’re facing a double-edged sword.

 

If you have so much credit card debt, that you are considering negotiating a settlement on your own, don’t be afraid to consider the route of bankruptcy. In a Chapter 7 bankruptcy, you won’t have to worry about these taxable events.  Your retirement accounts will almost always be exempt (meaning that creditors cannot look to the funds there to be made whole) and you will not be receiving 1099-Cs. In addition, a properly filed Chapter 7 bankruptcy (assuming that all of your assets are exempt) will discharge credit card debts and other unsecured loans completely.

If you have already settled your credit card debt, just remember that you will need to report the amount of the discharge when you file your taxes for that year.  You can make the argument that you were insolvent when you settled the debt to avoid being taxed on those amounts. But in doing so, you are relying on the IRS to see things your way.