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The Tax Consequences of Debt Settlement

For some people who are struggling with a large amount of debt, the process of debt settlement can be a great tool to help them regain control of their finances. Also called debt negotiation, debt settlement is a way for an individual to pay off their debt in full and create a clean slate with creditors. However, while settlement can be very helpful, it does have negative ramifications, especially when it comes time to file one’s yearly tax return.

What is Debt Settlement?

Settlement involves negotiating with creditors, typically credit card companies, to reduce the amount of money a person owes in exchange for one lump-sum payment. In some cases, debt settlement can result in an individual paying just 30-70 percent of the money they originally owed. Creditors are often willing to make a deal with an individual who owes them money if they believe that the person will default to bankruptcy if the amount they owe is not reduced. Settlement also helps creditors ensure they receive some money, while avoiding paying fees to third-party collection agencies.

Typically, only individuals who owe over 10,000 dollars qualify for debt negotiation. Additionally, consumers should keep in mind that the process only works for unsecured debt, like credit card debt. Home mortgages and student loans do not qualify for debt settlement. However, if an individual has more than 10,000 dollars of unsecured debt, negotiation can be a very helpful tool to regain a firm financial footing.

Debt Settlement and Taxes

However, debt negotiation is not without its downsides. One negative consequence of settlement is that it will likely damage a person’s credit score. Companies will report to credit reporting agencies that the debt was “settled,” which might scare away potential lenders in the future.

Another significant downside of debt settlement is the fact that the cancelled debt is considered taxable income by the IRS, and it must be reported on the following year’s tax papers. The amount of debt that was cancelled the previous year is considered money earned, so there is no way to avoid paying taxes on it. Individuals who are considering debt settlement should keep this in mind and consider whether they will be able to afford their tax payments the following year. However, if an individual believes they will be able to save enough to pay these taxes the following year, negotiation may be a solid debt management strategy to consider.

For more information on debt settlement and debt management, contact Advantage CCS today. Our experienced counselors can answer any questions you have about the process and consequences of debt settlement, and help put you a debt management plan designed to help you take charge of your bills and your financial future.