Can People Avoid Paying Taxes on a Debt Settlement in Phoenix?

When you settle a debt for less than what you owe, it feels like a financial victory—and often, it is. But what many people in Phoenix don’t realize is that settled debt can trigger a tax bill.
The IRS generally considers canceled or forgiven debt as taxable income, meaning you could end up owing taxes even after resolving your financial burdens.
So the big question is if you could avoid paying taxes on a debt settlement in Phoenix. The answer to this question depends on your specific situation, but there are legal ways to reduce or even eliminate the forgiven debt tax liability under certain conditions.
At Hilltop Law Firm, we help clients across Phoenix and Maricopa County understand their debt relief tax implications and explore strategies to resolve debt without triggering unnecessary IRS consequences.
What Is Debt Settlement?
Debt settlement is an agreement between a borrower and a creditor to resolve a debt for less than the full amount owed. For example, if you owe $10,000 on a credit card but the issuer agrees to accept $4,000 as payment in full, you’ve successfully settled the debt.
While this can dramatically improve your financial outlook, the IRS often considers the forgiven portion of the debt ($6,000 in the example above) as taxable income unless you qualify for an exclusion.
Why Is Forgiven Debt Taxed?
Under IRS rules, when a debt is canceled, forgiven, or discharged, the amount that is forgiven is typically considered “income” to the borrower. That means it may be subject to federal income tax—and possibly Arizona state tax as well.
Creditors are required to report canceled debt of $600 or more to the IRS using Form 1099-C, which you’ll also receive. That information will appear on your tax return unless you qualify for an exclusion or exception.
This is where many people are caught off guard—especially those already facing financial difficulty. The good news? There are ways to minimize or eliminate the tax consequences of a debt settlement.
Ways to Avoid Paying Taxes on Debt Settlement in Phoenix
While not everyone qualifies for tax relief, several legal avenues exist to help reduce or eliminate the tax burden from settled debts.
Insolvency Exclusion
The most common way to avoid taxation on canceled debt is by proving that you were insolvent at the time the debt was forgiven. Insolvency means your total debts exceed your total assets. If you qualify, you may exclude the forgiven debt from your taxable income up to the amount by which you were insolvent.
Example:
- You owed $50,000 and had $30,000 in assets.
- You settled $20,000 of that debt.
- Because your liabilities exceeded your assets by $20,000, the entire canceled debt may be excluded.
To claim this exclusion, you’ll need to fill out IRS Form 982 and provide documentation supporting your insolvency.
Bankruptcy Discharge
If the debt was forgiven as part of a Chapter 7 or Chapter 13 bankruptcy, it is not taxable. Debt discharged in bankruptcy is exempt from being considered income by the IRS.
This is why working with a Phoenix debt settlement lawyer is important. If you’re juggling multiple forms of debt, bankruptcy may be a better option than settlement alone.
Mortgage Forgiveness Debt Relief
If your forgiven debt was tied to your primary residence mortgage, you may qualify for exclusion under the Mortgage Forgiveness Debt Relief Act (extended through 2025). This applies to canceled debt from short sales, foreclosures, or loan modifications on qualified principal residences.
This provision has limitations and requires careful documentation—something your legal or tax advisor can help with.
Qualified Farm or Real Property Business Debt
In some cases, business owners can exclude canceled debt related to farm property or real estate business debt. This is a more niche category but worth noting for self-employed clients or those with rental properties.
What Happens If You Ignore the 1099-C?
If you receive a 1099-C for canceled debt and fail to report or address it, the IRS may assess penalties and interest or flag your return for audit. Even if you believe the income is excluded due to insolvency or bankruptcy, you must still file the proper forms to make that claim. This is why it’s essential to act early and consult with a professional.
Debt Settlement and Arizona State Taxes
Arizona generally follows federal tax treatment of canceled debt. If your forgiven debt is taxable at the federal level, it will also likely be taxable on your Arizona state return.
That said, exclusions like insolvency or bankruptcy also apply at the state level. To be safe, consult both a tax professional and a debt settlement attorney in Phoenix to fully understand your obligations.
Are You Considering Debt Settlement?
If you’re in the process of negotiating a debt settlement, here are some practical tips to minimize your future tax liability:
- Document your finances to prove insolvency if applicable.
- Request a breakdown of any canceled debt amounts in writing from the creditor.
- Consult a Phoenix bankruptcy or debt attorney before signing an agreement.
- Don’t ignore tax documents like the 1099-C; file the correct paperwork.
The more proactive you are, the better your chances of avoiding unwanted surprises at tax time.
How a Phoenix Debt Settlement Lawyer Can Help
Debt settlement isn’t just about negotiating a lower balance. It’s also about protecting your long-term financial health.
At Hilltop Law Firm, we take the time to understand your situation and tailor a plan that offers real, lasting relief—not just a quick fix. More specifically, we help clients:
- Explore debt relief options beyond settlement
- Evaluate the risks and benefits of early payoff, bankruptcy, or consolidation
- Work with tax professionals to prepare for 1099-C implications
- File for bankruptcy when necessary to discharge or reorganize debts
- Avoid forgiven debt tax liability by claiming insolvency or using other IRS exclusions
Speak With Our Trusted Debt Settlement Lawyer in Phoenix
If you’ve recently settled a debt or are thinking about doing so, don’t let tax issues catch you off guard. With the right strategy, it may be possible to avoid paying taxes on debt settlement in Phoenix and move forward with confidence.
Call Hilltop Law Firm at (602) 466-9631 to schedule your free consultation with our Phoenix debt settlement attorney today. Let us help you find smart, sustainable solutions to your debt challenges.