Debt Settlement Consequences

If a debtor cannot budget a way to repay past-due and delinquent debts, she may ask the creditor to settle the debt for a lesser value than the original amount. Most creditors will not accept a settlement offer unless a credit account is at 60 to 90 days past due. And consumers likely will see credit and tax consequences for settling debts with such methods.

Identification

Debt settlement requires a creditor to accept a lesser value for a loan or line of credit. If a debtor fails to meet the terms and conditions agreed upon in an original credit agreement and enters into debt settlement, future creditors will generally view him as a credit risk. As a result, the debtor may face difficulty obtaining new lines of credit and qualifying for the most attractive interest rates.

Tax Consequences

Debt settlement is a taxable transaction. Any forgiven balance that exceeds the tax-free threshold, which is $600, is taxable income and must be reported on the debtor's federal income tax return. Debtors must print and fill out IRS Form 1099-C, which is available for download on the IRS website. Tax returns must be filed for the filing year in which the forgiven balance is cleared, unless an extension is granted by the IRS.

Credit Consequences

Failing to meet the terms and conditions of a credit agreement will negatively affect a consumer's credit report and score. A debtor with a score of 680 could see a 65-point drop in his credit score versus a 125-point drop for a debtor who started with a score of 780, according to MyFico.com. A debt settlement report remains on a consumer credit file for seven years. However, a debt settlement will have less effect on a consumer's credit score as new creditors report positive information on the report and the debtor establishes a stronger payment history.

Considerations

A debtor can ask a creditor or debt collector to report settled debt as "paid in full." A paid in full report is more favorable than a "settled" or "settlement" report, according to Bankrate.com. To remove a settled account from a consumer's credit file altogether, the creditor must issue a deletion letter to the consumer credit bureau reporting the credit information and asking it to remove the account from the debtor's consumer file. Not all creditors will provide deletions on the grounds that deletions can be deceptive. Creditors can provide a written promise to issue the deletion within a specified period of time.