Unwanted tax surprises can await those in debt
Americans struggling with debt might have other nasty tax surprises this year: Whether it’s having to pay taxes on canceled debts or seeing deductions reduced due to delinquent loans, some taxpayers are on. the point of owing more than they realize, adding to an already confusing tax year. Some taxpayers also risk losing their reimbursement to debt collectors.
It is no wonder that according to NerdWallet Tax Report 2021, a third of tax filers feel stressed or anxious about owing money this year.
The pandemic turned the lives of many people upside down which can directly or indirectly affect their taxes. However, there are steps you can take to reduce the impact and prevent tax season from dealing another devastating blow to your finances.
Here are three ways debt can lead to tax surprises (and how to deal with them).
Taxes on canceled debt
If you’ve had a student loan or credit card debt forgiveness, so that forgiven debt is often included in taxable income in the year it is written off, says Richard Bolger, bankruptcy attorney and bankruptcy podcast host based in Fairfax, Va. You are required to report all taxable income, including canceled debts, to the IRS, and you will also likely receive a Form 1099-C in the mail with this taxable income listed.
To avoid surprises, Bolger suggests carefully reading the fine print that accompanies debt settlement offers, which often explain the tax ramifications, and asking questions before agreeing to anything. If you’re still not sure, a bankruptcy lawyer can help, he says.
Stephen Fishman, tax lawyer and author based in Olympia, Wash., Says the best way to prepare for the tax bill resulting from debt forgiveness is to put money aside up front so you’re ready to pay it before April 15th.
“If you can’t afford to pay the tax, you can work out a payment plan with the IRS,” he adds. The amount you owe depends on your tax rate, so the higher your tax bracket, the more you’ll have to pay.
Reduced deductions on forbidden loans
Thanks to COVID-19 relief programs and CARES Law, many Americans took advantage of forbearance programs for student loans and mortgages in 2020. This means that they have temporarily suspended their loan payments; interest usually continues to accrue during this period, but consumers do not pay it. And if you don’t pay deductible interest, that means you can’t consider it a tax deduction, which could potentially increase your tax bill.
“Taxes would likely be higher in a tax year where no deductible interest has been paid, all other things being equal,” Bolger said. But many Americans have opted for forbearance programs because they lost their jobs or other income, which could mean a lower overall tax bill.
Fishman also points out that when it comes to mortgages, many taxpayers can’t deduct them anyway because they don’t itemize their deductions, opting instead for the standard deduction. (However, taxpayers can deduct interest from student loans without itemizing it.) The overall impact of losing these deductions can therefore be negligible, unless your income stays the same (or increases) and you always opt for a forbearance program.
Losing your refund to debt collectors
Although collection agencies cannot take your refund directly from the IRS, it is possible that they can take it once it is in your bank account if the account is at risk of being subject to an IRS. garnishment due to a debt collection judgment, explains Lauren Saunders, associate director at the National Center for Consumer Law.
If the account is foreclosed, she adds, many states have laws that protect some of the money. “But in most states, the consumer must go to court to claim protection and must act quickly,” Saunders said.
Another option, she adds, is to request the reimbursement by paper check rather than direct deposit, or to immediately withdraw the necessary funds. This can prevent the money from being immediately seized by collection agencies.
It should also be noted that the federal government may withhold your tax refund in certain circumstances, such as if you owe overdue taxes or child support payments. In recent years, the IRS was also able to withhold unpaid federal student loans (although such collection activities are suspended until the end of September due to the pandemic).
If you receive a tax refund, as roughly 50% of filers expect, you could spend it paying off some of that debt to reduce your debt burden in the future. The NerdWallet report found that 32% of filers who were expecting repayment said they would spend the money on debt repayment.
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Kimberly Palmer writes for NerdWallet. Email: [email protected] Twitter: @kimberlypalmer.