In most cases, any debt that is forgiven will be subject to income taxes. Here is what you need to know.

Taxable Income from Canceled Debt

You can attempt to settle your debts with creditors on your own or with the services of a debt settlement or debt relief company that will charge you a fee for its services. (While there are legitimate debt settlement companies, the Consumer Financial Protection Bureau warns that they "can be risky" for several reasons.)

With certain exceptions, any debt you manage to have discharged or canceled by a creditor is considered taxable income under federal law. That means you must report it when you file your tax return for the year and pay taxes on it—even though you didn't receive any actual money.

As an example, suppose you have $20,000 in credit card debt, and, after negotiations, the lender agrees to accept $12,000 as payment in full. In that scenario, you would have $8,000 in taxable income to report on your tax return.

The process works a little differently with secured debt, such as an auto loan for which the car serves as collateral. (Credit card debt is typically unsecured debt.) If, for example, you fall behind on your car payments, the lender can repossess the vehicle and sell it. Whatever amount the lender receives from selling the car will reduce the debt you owe but generally not eliminate it. You can then attempt to settle the remaining debt for a lower amount. If the lender agrees, the amount you save becomes taxable income.

​Exceptions to Taxable Debt

The Internal Revenue Service (IRS) does list some exceptions to these rules. For example, the following types of debt are not considered canceled debts for tax purposes:

In addition, some debts that are considered canceled are not subject to income tax. Those include the following:

Reporting Canceled Debt on Ford 1099-C

When a creditor cancels all or part of a debt you owe in an amount that's more than $600, the company you owed money to will typically send you a Form 1099-C: Cancellation of Debt. It provides the information you'll need when you file your tax return for the year the debt was forgiven, including the amount of debt canceled and the date the cancellation occurred.

Note that you are still legally required to report the canceled debt amount even if the creditor does not send you this form. If you receive a 1099-C reflecting incorrect information, the IRS recommends contacting the creditor to request an updated form with the correct information.

Tax Implications of Settling Different Types of Debt

As mentioned, you'll owe federal income tax on any debt that is canceled or discharged, regardless of the type of debt, unless it falls into certain categories eligible for exclusion (described above).

That debt will be taxed at the same rate as your ordinary income. How much you'll have to pay will depend on your marginal tax bracket for that year. Currently, ordinary income is taxed at anywhere from 10% to 37% on the federal level.

In some cases, your state's tax rules may differ from the federal ones.

Strategies to Minimize Tax Consequences

If you plan to settle debt for less than you owe through debt settlement, there's not much you can do to minimize the tax consequences except to reduce your other taxable income as much as possible so that you qualify for a lower marginal tax rate.

You could also consider some alternatives that don't have tax consequences and shouldn't damage your credit score, either. For example, you might be able to work out a debt management plan to pay your debts off at a pace that is workable for you and acceptable to your creditors through a non-profit credit counseling agency. Many creditors would rather get their money back over a longer period of time than never get it back at all.

Another option, if you still have reasonably good credit, is to apply for a debt consolidation loan. These loans allow you to pay off your existing debts, after which you make payments on them, typically at a lower interest rate than you'd pay on your credit cards. You'll still have to pay your debts in full, but this can ease the pressure. A similar option, also if you have good enough credit to qualify, would be to transfer your existing credit card debt to a balance transfer credit card with a low or 0% promotional interest rate for a certain period of time.

​Are all Canceled Debts Considered Taxable Income?

Most canceled debts are considered taxable income on the federal level as well as in some states. Certain debts are excluded, however, including some student loan debts.

​How Do I Avoid Paying Taxes on Debt Settlement?

You typically cannot avoid paying taxes on settled debts unless they qualify for an exception. If you can't afford to pay the money right away, the IRS offers a number of options, including installment plans.

​What Happens if I Don't Report Settled Debt on My Taxes?

If you don't report settled debt on your tax return but the creditor supplies the information to the IRS, you could get hit with a tax bill or face an audit.

​The Bottom Line
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Debt settlement can make it possible to pay off your debts for less than you currently owe, but that won't get you off the hook with the IRS. Before you attempt debt settlement—either on your own or with the assistance of a third party—it's worth exploring other alternatives.