In managing credit card debt, individuals may want to reduce credit card debt through settlement, only to later receive an IRS notice suggesting the credit card debt settlement is taxable. This article briefly explains how a non-business credit card debt settlement can affect an individual's personal income taxes—helpful knowledge for consumers to use in managing credit card debt
Credit card debt is usually unsecured debt. Managing credit card debt by taking advantage of creditors’ offers to settle an outstanding balance for a fraction of the original amount borrowed results in “Cancellation of Debt.” Potentially taxable income generated from this transaction is often NOT taxable. It often qualified to be excluded from income taxation under the insolvency provisions of the tax laws when a consumer completes his or her personal income taxes or responds to an IRS notice. Here’s how.
Insolvency
Credit card debt settlement usually occurs because someone doesn’t have the resources to repay their debt according to the terms of the credit agreement. As such, they are probably insolvent. Insolvency here means having a negative net equity.
To determine insolvency, for the day before the debt is reduced, the consumer should list all the debt amounts owed (including utility bills and student loan debt) and list of all of his or her assets (home, car, household good, boat, land, clothing) and at what price they were initially purchased. Total all the assets, then subtract the total debts. If the result is a negative number, the consumer has a negative net equity, and insolvency applies.
Personal Income Taxes
To determine the amount of taxable income, if any, as a result of settling a credit card debt, the consumer should again list all the debt owed and total it. Then list and total the assets still held and their FAIR MARKET VALUES—that is, what would a willing buyer pay for them. Subtract the total of debt from the total of the asset fair market values. If the result is negative, the consumer is still insolvent, and none of the income from the reduced credit card debt is taxable income.
If the consumer is no longer insolvent, but solvent by an amount less than the credit card debt settlement, the consumer would pay personal income taxes only on the amount by which he or she now has a positive net equity.
Using Insolvency in Managing Credit Card Debt
Managing credit card debt gets easier when consumers know these rules. In summary, if an individual consumer negotiates a credit card settlement, is insolvent the day before the settlement is effected, and is still insolvent after the settlement is effected, that consumer should have no personal income tax liability for the amount of “forgiven” indebtedness. If the consumer's net equity is positive after the settlement is effected, the amount of taxable income resulting from the credit card debt settlement is limited to the amount of that positive net equity.
This article only applies to personal, non-business credit card debt reductions. Consumers should consult their tax professionals for the possible tax implications of other types of settlements.
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