This article was reprinted with permission from NerdWallet.
Americans struggling with debt could experience some additional nasty tax surprises this year: From the need to pay taxes on forgiven debts to reduced deductions from loans that are lenient, some taxpayers are willing to pay more owe than you might think, plus an already confusing tax year. Some taxpayers also run the risk of losing their refunds to debt collection agencies.
It’s no wonder that, according to NerdWallet’s 2021 Tax Report, a third of applicants are stressed or worried about owing money this year.
The pandemic created upheavals in the lives of many people that could directly or indirectly affect their taxes. However, there are steps you can take to lessen the impact and prevent tax season from causing another devastating blow to your finances.
Here are three ways debt can lead to tax surprises (and how to deal with it).
Taxes on debt relief
If you’ve had a student loan or credit card debt waiver, that canceled claim is often included in taxable income for the year it was waived, explains Richard Bolger, bankruptcy attorney and bankruptcy podcast host based in Fairfax, Virginia. You will need to report all taxable income, including canceled debts, to the IRS, and you will likely also receive a 1099-C form in the mail listing your taxable income.
To avoid any surprises, Bolger recommends reading carefully the fine print of debt settlement offers, which often explain the tax implications, and ask questions before reaching an agreement. If you’re still not sure, a bankruptcy attorney can help you, he says.
Stephen Fishman, a tax attorney and author based in Olympia, Washington, says the best way to prepare for the tax burden that comes from canceled debts is to put money aside beforehand so you are ready to take it to be paid by April 15th.
See also: What to do if you’ve already filed taxes but want to claim the $ 10,200 Unemployed Tax Break?
“If you can’t afford to pay the tax, you can work out a payment schedule with the IRS,” he adds. The amount you owe depends on your tax rate. The higher your tax bracket, the more you will owe.
Reduced Deductions for Forbearance Loans
Thanks to the COVID-19 relief programs and the CARES Act, many Americans took advantage of the student loan and mortgage leniency programs in 2020. That means they temporarily paused their loan payments. Interest will normally still accrue during this time, but consumers will not pay it. And if you are not paying deductible interest, it means you cannot consider this a tax deduction that could potentially increase your tax burden.
“In a tax year where no deductible interest was paid, taxes would probably be higher if all other things were the same,” says Bolger. But many Americans chose forbearance programs because they lost jobs or other income, which could mean a lower overall tax burden.
Fishman also points out that many taxpayers cannot deduct mortgages anyway because they don’t list their deductions and choose the standard deduction instead. (However, taxpayers can make interest deductions on unlisted student loans.) Therefore, the overall impact of losing those deductions can be negligible unless your income stayed the same (or increased) and you still opted for an indulgence program.
Loss of your refund to debt collection agencies
While collection agencies cannot take your refund directly from the IRS, it is possible that they will receive that refund once it’s in your bank account if the account is at risk of attachment due to a debt collection ruling, says Lauren Saunders, assistant director at National Consumer Rights Center.
If the account is garnished, many states have laws protecting some of the money. “But in most states, consumers have to go to court to claim protection and act quickly,” says Saunders.
Another option, she adds, is to request the refund by check instead of direct deposit, or to withdraw the money you need immediately. This can protect the money from being instantly confiscated by debt collection agencies.
Connected: Millions of Americans who were unemployed last year are facing another shock: a 2020 tax bill they can’t afford
It’s also worth noting that the federal government may withhold your tax refund in certain circumstances, such as: B. If you owe overdue taxes or child support payments. In recent years, the IRS has also been able to withhold unpaid federal student loans (although those collection activities will be suspended until the end of September due to the pandemic).
If you get a tax refund, as around 50% of applicants expect, you can use it to pay off some of that debt to ease your future debt burden. NerdWallet’s report found that 32% of applicants expecting a refund said they used the money to pay off debts.
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Kimberly Palmer writes for NerdWallet. Email: [email protected]. Twitter: @kimberlypalmer.