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One of the biggest drawbacks of settling debts is dealing with the tax implications of having your debt cancelled. The IRS requires you to include cancelled debt as taxable income on your tax return and requires businesses to report cancelled debts over $600. If your creditor cancels at least $600 of debt, the IRS will know about it. They’ll be expecting you to claim this as income on your taxes. You could face an audit if you don’t include the cancelled debt on your tax return.

Increasing your taxable income by adding in cancelled debt can decrease your tax refund – that’s if you still get a tax refund after increasing the amount of taxes you’re liable for. The worst-case scenario is that you end up with a tax bill after you’ve settled your debt.

The IRS does allow an exception to reporting cancelled debt as income on your tax return. You’ll still have to report the income, but you’ll be allowed to exclude it from your taxable income. To qualify for the exclusion, you must have been insolvent at the time your debt was cancelled. Insolvent means the total amount of your debt was greater than the value of any assets you owed. If the amount of the debt cancelled was less than the amount by which you were insolvent, you won’t have to pay taxes on the cancelled debt.

Insolvency Examples

You are insolvent by $100,000 and your cancelled debt was $30,000. Since your cancelled debt is less than your insolvency amount, you don’t have to pay taxes on the cancelled debt.

You are insolvent by $20,000 and your cancelled debt was $30,000. You can only exclude debt up to the amount of insolvency. So in this case, you can exclude $20,000 of cancelled debt, but still are liable for taxes on the remaining $10,000.

You are not insolvent. In fact, your assets exceed your liabilities by $40,000. You would have to include the entire $30,000 as income on your tax return.

Taking the Insolvency Exemption

To claim the exemption, you’ll have to file IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.

You’ll also need to keep detailed records about your insolvency status each time you settle a debt. When you send the final payment for your settlement, you should also calculate your net worth – a number that shows whether or not you are insolvent.

To calculate your net worth, first add up all your debts including mortgage and credit card debt that’s still owed. Then add up the value of all your assets, include any equity you’ve accumulated in your home. Subtract the value of your assets from the amount of your liabilities and that is your net worth. If the number is negative then you are insolvent by that amount. If the number is positive then you are not insolvent and you can’t take the insolvency exemption. Keep each calculation on a separate piece of paper and file it away with your tax documents.

Article Source: http://www.articlesbase.com/personal-finance-articles/dealing-with-taxes-on-your-settled-debts-4679242.html

About the Author

This is a post by Frank Collins. Frank is a personal finance writer who specializes in topics related to credit, savings and debt relief options like debt settlement.