This is one of the potential pitfalls of debt consolidation that many consumers are unaware of until they receive a Form 1099-C from a creditor come tax time.

When debts are consolidated and/or forgiven the creditor must report it to the Internal Revenue Service (IRS) as a business loss if the amount is more than $600.00. The debtor will then receive a Form 1099-C that reports the business loss to the creditor as gross income to the debtor even though no real money was exchanged. This phantom income can significantly affect a debtor’s tax liability. Some debtors may even disregard the 1099-C thinking that they have been released from any debt liability to that creditor.

If you have not filed for bankruptcy you must report the discharged debt as taxable income on that year’s tax return. If you have filed for bankruptcy and you receive a 1099-C for a debt you thought had been discharged you should immediately notify your bankruptcy attorney. Debtors who have filed bankruptcy may qualify for an exclusion to the 1099-C. They must file a Form 982 with their tax return along with the 1099-C which allows them to eliminate their debt liability to that creditor.

The bottom line is if you settle a debt with a credit card and it is for more than $600 you will be taxed on that forgiven debt. If you file bankruptcy then you do not have to pay taxes on the debts that are wiped out or forgiven.