Debt settlement can be an excellent solution if you're getting crushed under unpaid loans and credit card bills. However, when a creditor forgives $600 of debt (or more), the IRS considers it an income. And just like any other income it's taxable. So, how to avoid paying taxes on debt settlement?

The most effective way to get out of paying taxes on a debt settlement is to declare yourself bankrupt or insolvent during that period. You might also qualify for special exclusions and exceptions for being a student, farmer, homeowner, or businessman.

Paying taxes on forgiven debt might be the last thing someone in a financial struggle would want. Therefore, the tax authorities have certain codes to help you out. Follow this discussion to learn more.

5 Ways To Avoid Paying Taxes On Debt Settlement

You don't have to pay taxes on a forgiven debt if there's solid proof that you're incapable of doing so. This also applies to someone who has taken a forgiven loan to invest in education, agriculture, or business. Based on these principles, here are some of the ways you can avoid paying taxes on debt settlements-

Insolvency

Do you owe more to lenders than your total amount of assets? In that case, you are insolvent. And as per the Internal Revenue Code's Section 108(a)(1)(B), insolvent taxpayers are excused from considering forgiven debts as income. This code has created the insolvency exclusion in tax payments on debt settlement.

However, there's a condition. You have to show the authorities that you became insolvent just before the debt settlement.

So, use the IRS-provided insolvency worksheet to document the itemized cost of your total assets. This should be according to the market price of these assets during the settlement period.

Record the total cost of your liabilities on the same sheet. The difference in the document will tell the authorities you're insolvent and qualify for the exclusion.

In addition, you need to fill out a Form 982. This will be the formal report to the IRS regarding the exclusion. In the form, mention the extent of your insolvency and how much debt the lenders had forgiven. Finally, attach it to the Federal Income Tax Return for the settlement year.

Declare Bankruptcy

Title 26, Section 108 of the U.S. Code creates the bankruptcy exclusion for debt settlement. According to the code, if creditors have forgiven a taxpayer's loan after he filed for a Title 11 bankruptcy then the authorities won't regard the settled debt as taxable income.

The Title 11 bankruptcy includes Chapter 7, 11, and 13 bankruptcy.

Here, Chapter 7 refers to the liquidation bankruptcy. This means you will sell assets like a fancy car, vacation home, or similar expensive but non-essential items to pay off creditors. Remember, these are secured debts. In other words, the creditors have a claim on your essential properties if you don't pay them off.

Once you settle the secured debts and have no nonexempt assets left to sell, your unsecured debts will be discharged. These are debts like medical bills where the creditors don't hold your assets as collateral. And since you are bankrupt now, the IRS won't deem these forgiven debts as taxable income.

Meanwhile, Chapter 11 (for businesses) and 13 (for wage earners) are re-organization bankruptcies. They allow the debtor to keep their property while they restructure the debt and pay it back over 3-5 years.

The taxpayer must submit a petition to the bankruptcy court while filing under any of these chapters. This mostly means detailed documentation of your financial situation, credit counseling, and reorganization plans to the court. To report the bankruptcy exclusion to the IRS you will attach a form 982 to your tax return.

Invested In Farming

The IRS has tax provisions to save dedicated farmers from financial problems. These provisions have created the category of Qualified Farm Indebtedness. It includes loans that a farmer took to invest directly in farming operations and equipment. The tax authorities don't consider such forgiven loans as gross income.

However, there are two conditions. Firstly, fifty percent or more of your gross revenue for the preceding three years has to be from farming. This will prove that the business which had its loan forgiven is an agricultural one.

Secondly, the entity that canceled your debts must be a person or organization that routinely lends money. The entity isn't eligible if they're your relative or someone who profits off your farming business.

Business Property

Suppose, you own a shop or building out of which you conduct business. You might have taken a loan against it to improve certain aspects of the building. Afterward, your business suffered losses and you failed to pay back the lender. So, you negotiated and came to a debt settlement with the creditor to save your shop.

In the above case, you won't have to pay any taxes on the debt your creditor had forgiven. The Qualified Real Property Business Indebtedness provision excludes your canceled debt from gross income.

However, this won't apply if you are a C-Company. The QRPBI exclusion also doesn't work when the real estate is a mere investment for the company and no actual business is conducted there.

To compensate for the debt forgiven under QRPBI, you must reduce the property's basis. For instance, you may have bought the property for 400,000 dollars. You later took a loan of $70,000 to enhance various features of the business. So, the property's basis is now $470,000.

When you aren't able to pay back the loan, your creditor settled for $40,000. As per the exclusion, you won't have to pay taxes for the $30,000. However, it will be deducted from your property's basis and bring it down to $4,40,000. When you sell the property in the future, the tax calculations will be on this new basis.

Gifts and Inheritance

You can avoid paying taxes on a debt if someone forgives it as a gift. Although, the giver might have to pay gift taxes. The same goes for bequests and inheritances. You won't pay any taxes if someone forgives you loans with a will.

However, you must record and keep proper documentation of this forgiveness as a gift or bequest. Here, you might require professional legal help to arrange proper paperwork. Without the relevant documentation, the IRS is unlikely to consider your case for exclusion.

How To Not Pay Loans After Mortgage Debt Settlement?

During the housing market crash of 2007, many homeowners were failing to pay back their mortgages. Consequently, they were on the brink of losing their homes to lenders. The Mortgage Forgiveness Debt Relief Act was passed to help homeowners during that crisis.

According to the act, if the homeowners settled their mortgages with the creditors then the forgiven amount won't be considered as gross income. It applies to homeowners who have restructured their mortgage to make it more affordable. Or, those who are at risk of foreclosure due to not paying the debt.

This created the Qualified Principal Residence Indebtedness (QPRI) tax provision. So, those who fall under the QPRI exclusion won't pay any taxes on their settled mortgage debts. This is determined by the following factors-

● You had taken the forgiven debts against your main home. So, if you hadn't gone for the settlement, you would have become homeless.

● Documents and other relevant proof that you had used the mortgage loan exclusively to buy or improve the home and nothing else.

● The limit for QPRI can't be more than $750,000 (or half this amount if not filing as a couple). This applies to forgiven mortgage debts from 2018 to 2025.

● This exclusion applies to debts forgiven or agreed (in writing) to be forgiven before 1 January 2026.

How To Avoid Paying Taxes On Canceled Student Loans?

Three categories of student loan forgiveness make you eligible for a tax exclusion.

Firstly, individuals in certain lines of work can exclude their settled student loans from their main income. Those who fall under the American Rescue Act or are in a Student Loan Repayment Assistance Program will also qualify. Here are some of the considerations-

Public Services

Are you working full-time in a public service job? You can then make 120 qualifying payments towards your student loan and have the rest of the debts discharged. The IRS won't deem these canceled loans as taxable income.

Teachers and Health workers

Another way to qualify for this exclusion is to become a teacher. Dedicate five consecutive academic years teaching full-time in a low-income school and you can't have loans forgiven up to $17,500. You won't have to pay any taxes on the debt settled under the Teacher Loan Forgiveness program.

Health professionals working in poorly served areas can also enjoy the same exclusion. In this case, you can take the help of the NHSC Loan Repayment Program.

American Rescue Plan Act

Did you settle a student loan after December 31, 2020? Then you probably won't have to pay any taxes on it. This is due to a provision the American Rescue Plan Act created which exempts forgiven student loans from taxable income. However, this is only a temporary relief and applies to loans forgiven until the end of 2025.

Conclusion

Someone who is asking his lender to forgive some part of their loan is obviously in financial distress. Paying taxes on the canceled debt certainly isn't going to help their situation.

This is why the exclusions and exceptions are there to give you some relief. However, your documents and evidence should be in crisp condition if you want to take advantage of those.

Of course, there will be many people who don't qualify for these exceptions. They have no choice but to go through the ordeal. In that case, a debt management plan can be an effective way to survive the situation.