Good news! Your creditor has agreed to settle your $20,000 Citi Card credit card for a fraction of what you owe! You save thousands of dollars and have one less debt to worry about. You’re on your way to resolving all of your debt.
There’s just one problem. You may be on the hook to the IRS for the forgiven debt. So that could be a few thousand dollars that you now owe.
Why does the IRS tax you for your forgiven debt?
This is understandable as you would have had to use your income to pay down your debt and now you have that money available for other needs.
But, you may not have to pay any taxes thanks to the bankruptcy code.
If you are insolvent at the time of the settlement, meaning you have more liabilities than assets, then you will not have to pay any taxes on the forgiven debt.
The publication you want to review is IRS publication 4681. You need to read about the exemption for insolvency.
You need to calculate your net worth and if it’s negative, you won’t owe any money on your forgiven credit card debt.
Let’s take a look at an example from CreditCards.com: