Credit card banks may offer settlement at a reduced amount if you get behind and fail to keep current on your payments. My colleague, Doug Jacobs, talks about Negotiating Your Credit Card Balance in an earlier series of articles on this website. However, if a bank or other finance company agrees to settle a debt for less than the balance due, IRS regulations require them to file a 1099-C reporting the cancellation of debt income you receive from the settlement.
While settling a debt for less than the balance due improves your financial position and may allow you to avoid bankruptcy, this benefit comes at a price. The difference between the debt that is due and the amount you pay will be included in your income for tax purposes by the IRS in the year when the debt was cancelled. If you do not report the income on your tax return, the IRS will send you a notice from the under-reporter unit and then assess more tax (and a penalty) if you can not show there is some reason to exclude the amount.
There are several exceptions to the rule that can avoid tax on the cancelled debt. If the debt is discharged in bankruptcy, it is not considered to be income to you. Despite the credit counseling requirement of the bankruptcy law, you may be better off with a bankruptcy discharge than a settlement of your debt at a discount.
