Does Claiming Insolvency Hurt Your Credit?

The Internal Revenue Service defines insolvency as having more debts than assets. Some people claim insolvency to the IRS when trying to escape tax penalties for settling credit cards and other debts. An official form is necessary for the the declaration, but the information does not appear on credit reports or affect a person's credit scores.

Considerations

Having more debts than assets is not a true indication of a person's credit qualifications. A college graduate working for three years in a first job may have an outstanding 720 credit score because of great credit management and never missing a payment while keeping balances low. Yet, the person may qualify for insolvency because of $80,000 in student loan debt that the student is faithfully paying back as agreed. A homeowner who has never missed a payment on any account also could have a 700-plus credit score yet qualify for insolvency because her primary asset -- the house -- lost half its value during a housing crisis.

Misconceptions

Declaring insolvency isn't the same as declaring bankruptcy. Bankruptcy does hurt credit because it is an admission that a debtor cannot repay his debts. Bankruptcy filings remain on credit reports for a minimum of 10 years and can make it very hard for the debtor to qualify for new loans and credit at reasonable rates.

Identification

Debt settlement allows people to resolve unsecured debt, such as credit cards, for as little as 20 percent of the balance -- although most settlements range from 20 to 70 percent, according to SmartMoney. A hidden cost exists with debt settlement, however. The IRS requires creditors and debt collectors to issue 1099 tax forms to people who realize savings of at least $600 during debt settlement. The IRS treats debt settlement savings as income, meaning a debtor settling $40,000 in credit card debt for $8,000 must report $32,000 in additional income to the IRS by submitting 1099 forms from creditors. However, by claiming insolvency the debtor may qualify for an exemption and not pay taxes on the additional income.

Advice

People concerned about insolvency and debt settlement should speak with a tax advisor. The tax advisor can determine if the debtor qualifies for insolvency under IRS guidelines.