The Tax Consequences of Debt Settlements

Debt settlement is the process of negotiating with a creditor to settle your debt for a fraction of what you owe. By agreeing on a debt settlement amount, the creditor avoids the possibility that you will default on the full amount, and you get part of your debt forgiven in exchange for paying the rest. However, the Internal Revenue Service considers forgiven debt to be a form of income, so you may have to pay income tax on the amount your creditor forgives.

Debt Settlement

When you are drowning in debt, debt settlement may seem like an ideal solution. You simply pay what you can afford, and the creditor forgives the rest of your debt. Some people negotiate debt settlement themselves, while others go through specialist companies. In some cases, your creditor may even call you to make an initial settlement offer. Once you formally agree on a settlement amount, and make the required payment, you no longer owe the debt.

Tax Liability

As of 2010, the IRS treats forgiven debts totaling more than $600 as taxable income. It may not seem fair at first, but it does make sense. If you owe $10,000, and your creditor forgives $3,000, it's as though the creditor has given you $3,000. Therefore, the creditor must send you IRS Form 1099-C (Cancellation of Debt). At the end of the tax year, you must pay income tax on the forgiven debt, just as you do on other forms of income. One exception to this rule is forgiven mortgage debt. From 2007 to 2012, the Mortgage Forgiveness Debt Relief Act makes up to $2 million of forgiven mortgage debt tax-free. You may also be able to avoid paying taxes on forgiven debt if you are insolvent (i.e., your debts total more than your assets).

Credit Consequences

In addition to creating a tax liability, debt settlement will seriously damage your credit score. Debt settlement stays on your credit report for seven years, making you a high-risk borrower in the eyes of prospective lenders. If you demonstrate consistent financial responsibility after settling your debt, the settlement will eventually have less of an impact on your score. However, it will remain on your credit report --- and affect your creditworthiness --- until it expires automatically.

Considerations

Debt settlement is usually a last resort for people facing bankruptcy. If you have reached this point, it's likely that your credit score is already quite low. Debt settlement will hurt it, but not nearly as much as it would if you had a clean credit history. For this reason, debt settlement is often preferable to bankruptcy, which does greater damage to your credit score and can stay on your credit report for up to a decade. However, you must also consider the amount of tax liability debt settlement will create, especially if you are not already insolvent. In some cases, this additional "income" may even push you into a higher tax bracket. The IRS does not view debts discharged through bankruptcy as taxable income, so for some debtors, bankruptcy may be a better option.