Are you in debt? Then you might experience some unpleasant tax surprises
(NerdWallet) – Americans struggling with debt could experience some additional nasty tax surprises this year.
From the need to pay taxes on canceled debts to reduced deductions due to indulgent credit, some taxpayers are willing to owe more than they may be aware, adding to an already confusing tax year. Some taxpayers also run the risk of losing their refunds to the collection agencies.
No wonder, according to NerdWallet’s 2021 Tax Report, a third of applicants this year are stressed or worried about owing money.
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 save tax season from another devastating blow to your finances.
Here are three ways debt can lead to tax surprises (and how to deal with it).
Owe taxes on canceled debts
If you’ve been granted student loan or credit card debt forgiveness, those canceled debts are often reflected in taxable income for the year in which they were canceled, explains Richard Bolger, a bankruptcy attorney and bankruptcy podcast host based in Fairfax, Virginia. You are required to report all taxable income, including canceled debts, to the IRS, and you will likely also receive a Form 1099-C in the mail listing that taxable income.
To avoid surprises, Bolger suggests reading carefully the fine print on debt settlement offers, which often explains the tax implications, and asking questions before agreeing to anything. If you’re still unsure, a bankruptcy lawyer can help, he says.
Stephen Fishman, tax attorney and author based in Olympia, Washington, says the best way to prepare for the tax bill that comes from canceled debt is to put money aside beforehand so you’re ready to take it up to be paid by April 15th.
“If you can’t afford the tax, you can work out a payment plan with the IRS,” he adds. The amount you owe depends on your tax rate. The higher your tax bracket, the more you owe.
Reduced deductions for loans on deferral
Thanks to COVID-19 relief programs and the CARES Act, many Americans took advantage of student loan and mortgage deferral programs in 2020. That means they temporarily paused their loan payments; Interest is usually still due during this time, but consumers do not pay it. And if you don’t pay deductible interest then you can’t take it as a tax deduction, which could potentially add to your tax bill.
“In a tax year in which, other things being equal, no deductible interest was paid, taxes would probably be higher,” says Bolger. But many Americans have opted for deferral programs because they lost jobs or other incomes, 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 claim interest deductions on student loans with no breakdown.) So the overall impact of losing those deductions can be negligible unless your income has stayed the same (or increased) and you still opted for a deferral program.
Loss of your refund to debt collection agencies
While debt collection agencies can’t take your refund directly from the IRS, they are able to accept it once it’s in your bank account if the account is at risk of seizure due to a debt collection, says Lauren Saunders, associate director at the Nationales Center for Consumer Law.
If the account is seized, she adds, 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,” Saunders says.
Another option, she adds, is to request a paper check refund instead of a direct deposit, or to withdraw funds you need immediately. This can protect the money from being instantly confiscated by debt collection agencies.
It’s also worth noting 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 has also been able to withhold unpaid federal student loans (although these collection activities will be on hold until the end of September due to the pandemic).
When you get a tax refund, which is what around 50% of applicants expect, you can use that to pay off some of that debt to ease your debt burden in the future. NerdWallet’s report found that 32% of applicants expecting a refund said they would use the money to pay off debt.
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Kimberly Palmer writes for NerdWallet. Email: [email protected] Twitter: @kimberlypalmer.
The Unwelcome Tax Surprises May Be Waiting For Those With Debt article originally featured on NerdWallet.
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