Having so much debt to settle can be overwhelming; one single slip up or carelessness, and you could find yourself staring at several debts with high interest rates and late payment fees. If you are unlucky, you could face lawsuits from stern creditors, which most times result in wage garnishment. As a debtor struggling with so much debt, one of the best ways to pull through with ease is by taking a debt consolidation loan. However, before you consider taking this loan, you should ask yourself one important question: “Are debt consolidation loans taxable?”
A debt consolidation loan, like all loans out there, isn’t taxable. This loan isn’t considered as an income, thus, making it untaxable. You are only required to pay taxes on discharged (canceled or forgiven) debts.
Research shows that about 80% of Americans are in debt. This means that 8 in every 10 Americans is struggling with one debt or the other. While repaying a debt, especially a huge one, remains a hassle, there are a few debt relief methods that can help you pay back what you owe fast, without many difficulties. Debt consolidation is one of those methods, and it involves merging your debts then taking a huge loan (one with favorable repayment terms) to settle the debt. What are debt consolidation loans and their tax implications? How does it work? Is this loan taxable? Read on to find out more.
Is Cancellation of Debt Income Taxable?
Are Debt Consolidation Loans Taxable?
The IRS expects individuals to pay taxes on income and business profits. Provided the income is made from legal means and is above the minimum income amount, you are expected to file a federal tax return. Failure to abide by this forever-old rule could deprive you of many benefits and leave you at the mercy of severe tax consequences.
While the IRS tax rules are strictly for income and business profits, some debtors must pay tax on loans. Of course, loans aren’t income, thus making them untaxable. However, if the creditor decides to cancel the debt, it becomes an income since you aren’t required to pay it back. In that case, the IRS demands that you pay taxes on the amount you don’t pay back.
However, while you are trying to understand how tax and debt work, as regards a forgiven or canceled loan, you may want to find out if the same applies to a debt consolidation loan. But, before I delve into that, let’s look at what debt consolidation is.
What Is Debt Consolidation?
As the name implies, debt consolidation involves combining multiple debts, usually high-interest debts like credit card bills, into a single payment. Put differently; it involves taking out a new loan to settle other liabilities and consumer debt.
This debt-relief method may be an ideal debt repayment strategy for you if you are fortunate enough to obtain a loan with a lower interest rate. That will help you lessen your overall debt and reorganize it so you can settle it faster, without many difficulties.
Suppose you struggle to pay a manageable amount of debt and want to reorganize numerous bills with diverse interest rates, payments, and due dates. In that case, it makes sense to embrace debt consolidation.
How Does Debt Consolidation Work?
Debt consolidation works in a simple way. To consolidate debt, you are required to apply for a personal loan, balance transfer credit card, or another consolidation tool through your bank or another creditor.
In the case of a debt consolidation loan, the lender may decide to pay off your debts directly, or you can take the cash and settle your outstanding balances. In addition, several balance transfer credit cards have a designated process for consolidating a cardholder’s existing card.
After Consolidating Your Debt, What Next?
Once your debts are settled completely with the new loan funds, you will have to make a single payment on the new loan every month. While this debt relief method always reduces the amount a borrower owes each month, it prolongs the loan period of the consolidated loans. Combining your debts makes them more organized and easier to settle, especially for those who struggle to manage their money.
Is This Debt Relief Method for You?
Debt consolidation isn’t a quick fix to your debt problems, neither does it work like magic. You will need to put in work for it to be successful. Before you consider embracing this technique, you need to understand that it is not for everyone.
If you are struggling to pay several high-interest debts, I would advise that you consider this method. However, if your debt load is small, I’ll suggest that you don’t bother consolidating it. Instead, consider a do-it-yourself method like the effective debt snowball or debt avalanche method.
Should I Pay Tax on My Debt Consolidation Loan?
According to the IRS, when you lend money from a bank or a lender, it is considered debt if you are obliged to pay it back. Such a debt is not taxable since you are required to pay it back. Since you’ll be paying back a debt consolidation loan, it isn’t taxable. However, it becomes taxable if the creditor discharges it.
Below are a few loans that are not taxed as income:
- Personal loans for credit card consolidation or significant purchases
- Mortgage loans to buy personal real estate or investment property
- Student loans
I often hear people ask this question “How does the cancellation of debt affect taxes?” I consider it a good question, and I advise that debtors understand this to avoid getting into the IRS’s bad book.
What Happens When a Debt Is Sold to a Collection Agency?
How Does Debt Consolidation Affect Your Tax Return?
Some debt relief methods affect your tax return. One of those methods is debt settlement. Debt settlement is the process of resolving delinquent debt for less than the amount you owe by promising to offer the creditor a big lump sum payment. According to the IRS, you are required to pay tax on the amount you didn’t pay back. This means that a debt settlement and taxes are somehow intertwined. But what of debt consolidation? How does it affect your tax return?
Debt consolidation doesn’t affect your tax return as you are required to pay back what you owe. It will only affect your tax return if the creditor decides to cancel the debt totally or partially.
Individuals who embrace debt settlement ask the question, “how much tax do I pay on a settlement?” the tax you are required to pay depends on the amount you didn’t pay back. Speak to a financial expert for more insights.
