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3 ways debt can lead to surprises this tax season

Americans struggling with debt could have other nasty tax surprises this year: from having to pay taxes on canceled debt to seeing reduced deductions due to loans that are subject to forbearance, some taxpayers are about to owe more than they realize, adding to an already confusing tax year. Some taxpayers also risk losing their refund to collection agents.

It’s no wonder that according to NerdWallet’s 2021 tax report, one-third of filers feel stressed or anxious about owing money this year.

The pandemic has turned the lives of many people upside down which can directly or indirectly affect their taxes. However, there are steps you can take to lessen 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).

1. Tax Duty on Canceled Debt
If you’ve gotten a student loan or credit card debt forgiven, that forgiven debt is often included in taxable income in the year it’s forgiven, explains Richard Bolger, bankruptcy and bankruptcy podcast host based in Fairfax, Virginia. You are required to report all taxable income, including debt forgiveness, to the IRS, and you will also likely receive a Form 1099-C in the mail with that taxable income listed.

To avoid surprises, Bolger suggests carefully reading the fine print that comes with debt settlement offers, which often explain the tax ramifications, and asking questions before agreeing to anything. If you’re still unsure, a bankruptcy attorney can help, he says.

Stephen Fishman, a tax attorney and author based in Olympia, Wash., says the best way to prepare for the tax bill that comes with debt forgiveness is to put some money aside ahead of time so you’re prepared. to pay it before April 15.

“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 will have to pay.

2. Reduced loan deductions during forbearance
Thanks to COVID-19 relief programs and the CARES Act, many Americans have taken advantage of student loan and mortgage forbearance programs in 2020. This means they have temporarily put their loan payments on hold; interest generally accrues during this period, but consumers do not pay it. And if you’re not paying deductible interest, that means you can’t treat it as a tax deduction, which could potentially increase your tax bill.

“Taxes would likely be higher in a tax year where no deductible interest was paid, all things being equal,” Bolger said. But many Americans have opted into forbearance programs because they lost 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 take student loan interest deductions without itemizing.) So the overall impact of losing those deductions may be negligible, unless your income has stayed the same (or hasn’t). has increased) and you have opted for an opt-out program anyway.

3. Losing your refund to debt collectors
Although collection agencies cannot directly withdraw your refund from the IRS, they may be able to take it once it is in your bank account if the account is at risk of seizure due to a debt collection judgment, says Lauren Saunders, associate director at the National Center for Consumer Law.

If the account is seized, she adds, many states have laws that protect some of the money. “But in most states, the consumer must go to court to assert protection and must act quickly,” Saunders said.

Another option, she adds, is to request reimbursement by paper check rather than direct deposit, or withdraw the necessary funds immediately. This can protect 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 could also withhold unpaid federal student loans (although these collection activities are halted until the end of September due to the pandemic).

If you receive a tax refund, as about 50% of filers expect to do, you could use it to pay off some of that debt to reduce your debt burden in the future. The NerdWallet report found that 32% of filers awaiting repayment said they would use the money to pay off their debt.

About the Author: Kimberly Palmer is a personal finance expert at NerdWallet. She has been featured on “Today” and The New York Times