Do you have overwhelming revolving debt? For Americans who have experienced a crisis that ballooned their debt, the inability to pay it off causes anxiety often to the point that they cannot sleep. One of the least expensive and least traumatic ways to handle such debt is through settlement.
Debt settlement has many financial advantages, but some people are concerned by the possible tax bite that comes from having a large debt forgiven. And while it's true that traditionally, you may owe income taxes on forgiven debts, there are ways to minimize or eliminate that bill. How? Here are two steps to take.
1. Calculate Insolvency
One of the only ways to avoid having to pay taxes on forgiven debt is to prove that you are insolvent when the cancellation occurs. Insolvent simply means that your liabilities are larger than your debts, resulting in a negative net worth.
How can you show that you are, indeed, insolvent? The IRS provides guidelines for such a calculation as well as a worksheet on which you can do the math. First, gather together paperwork regarding all assets you own, including your home, vehicles, bank account balances, jewelry, life insurance, and even deposits held by your landlord. These are your assets.
Then, gather documentation of debts you owe as of the date of debt forgiveness. For most people, such debts could be mortgages, car loans, student loans, credit card and personal loans, medical bills, past due taxes, and utilities for which you are in arrears. It's vitally important to scour your finances to come up with all possible loans to count as liabilities against your assets.
Once you do the math on the worksheet, you may find that you have a negative net worth. This is insolvency, and you can correctly claim such on your tax forms and receive an exemption from the tax due on debt forgiveness. If your net worth is still positive, though, move on to step two.
2. Time Your Forgiveness
If you know that you will owe taxes on cancelled debt, time the transaction to minimize the impact. Estimate your tax bill for the current year as well as the expected changes for the upcoming year. If there are any significant changes — like changing amounts of dependents or tax deductions — request debt settlement in the year in which your tax bill would be lower.
If you wait until the new year to settle a debt, you can alter your income taxes through methods like harvesting capital gains losses, accelerating or putting off some earnings, and timing retirement contributions to minimize your effective tax rate. Work with an experienced accountant to learn more about timing this type of windfall.
If you plan ahead for the tax consequences of debt settlement, you can enjoy the maximum benefits for minimum consequences. And as a result, you'll be able to start moving forward with your financial life.