By taking advantage of a debt settlement, you may be able to satisfy an outstanding debt for much less than you actually owe. Both you and your creditor can benefit from a settlement agreement. The creditor benefits by receiving a payment it would not have otherwise received, and you benefit by avoiding a lawsuit. A debt settlement agreement can, however, give rise to legal issues that all consumers should be aware of in order to avoid unpleasant surprises later on.
Taxes
If your creditor forgives more than $600 of your original debt, you can expect to receive a 1099 form at the end of the year that details the amount of the debt that was forgiven. Because you did not pay the whole debt, the creditor is permitted to claim the unpaid portion of the debt as a tax loss--and you must pay taxes on it. Any forgiven debt is treated as taxable income by the IRS. Failure to pay taxes on the forgiven debt constitutes tax evasion, which can result in steep fines or even imprisonment.
Debt Transfer
In some cases, paying a debt settlement to a creditor does not stop the creditor from selling the debt to a collection agency. This is usually a case of mismanaged records, but until a creditor puts a settlement agreement in writing, the agreement is not official and binding. Thus, it can legally sell the debt to a collection agency which can, in turn, sue you for the amount you still owe. If you do not keep up with the paperwork proving that you settled the debt, you may be forced to defend yourself in court for a debt you already paid.
Debt Negotiation Companies
Although debt negotiation companies may claim to be able to help you negotiate with your creditors, the Federal Trade Commission warns that not all debt negotiation companies are legitimate. Consumers should beware of any debt negotiation or settlement company that makes claims of being able to settle your debts for pennies on the dollar and preserve your credit rating. Debt negotiation companies have been such a problem for consumers in the past that 12 states currently outlaw the practice of settling a third party's debts for profit. In addition, a debt negotiation company may claim that it will "handle" any collection accounts for you, but in the event that a collection agency sues you over an unpaid or unsettled debt, the debt negotiation company will not provide you with legal representation.
Accurate Credit Reporting
The Fair Credit Reporting Act requires that all creditors report their clients' debts accurately. After a debt settlement, the debt on your credit report should update to "settled" on your credit report. If it does not, you have the right to report the inaccuracy to the credit bureaus and request a full investigation. You may also add a consumer statement to your credit report explaining that the debt was settled. You even have the right to sue the creditor if it continues to refuse to accurately update your credit file.
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