Financial institutions are required to report canceled debts over $600 (the portion forgiven during the settlement transactions)
to the IRS, and the debtor is required to report that as income
on their tax return.
However, the IRS permits you to offset any "income" from
canceled debts up to the amount you were "insolvent" at
the time the debts were canceled. You are "insolvent" if
you owe more than you own, or in other words, if you have a negative net worth. If you're deep in debt, it's not likely that you have
a positive net worth, so it's rare that a client would have to
pay taxes on the forgiven debt balance.
The exception might be
an individual with a high level of home equity, which might make
the overall net worth positive and thereby eliminate the insolvency exclusion. However, this is the exception rather than the rule.
Our view is that even in the unlikely circumstance that you
might owe tax on the forgiven debt balance, you'll still be way
ahead of the game by eliminating your debt balances sooner rather
than later.
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