Anyone who has ever been in credit card debt knows just how burdensome it can be. Debt seemingly pervades your entire life, limiting your disposable income, causing stress, and potentially dragging down your credit score. If debt is mishandled, not only will these effects be magnified, but the possibility of a lawsuit will arise as well. As a result, it’s no surprise that indebted consumers are typically desperate for a solution. They want to stop hemorrhaging money on interest, and most importantly, they want to have one less worry on their minds.
A debt settlement—agreeing to payoff your defaulted debt with a lump-sum payment that is less than what you actually owe—can therefore seem like an extremely attractive option for consumers who are in serious financial trouble. However, in jumping at such an opportunity, many people fail to fully consider the overall pros and cons and ultimately benefit less than they initially imagined they would.
One such factor that people often overlook is the relationship between debt settlement and taxes. When you receive a loan, which is essentially what a credit line is, you don’t have to include it as part of your taxable income precisely because of your agreement to repay the lender. After all, it’s not income if you have to eventually give it back. This all changes, however, when you reach an amended agreement with your creditor, which requires you to only repay a portion of what you initially borrowed.
At this time, the difference between what you borrowed and what you repay gets classified as income and is, as a result, taxable. Therefore, while you might consider a settlement that requires repayment of only a small portion of your debt an unqualified victory, this win might not be as dramatic as you think.
And while some might be tempted not to report the money you save as taxable income, creditors are legally required to report forgiven debt to the IRS via 1099-C forms, which means a failure to report will result in tax discrepancies. Your creditors are also required to send you such documentation, so be on the lookout for it if you agree to debt settlement.
Still, we’re talking about taxes here, so we’d be remiss if we didn’t mention loopholes. Therefore, note that forgiven debt is not taxable if you’re insolvent— the cost of your debt exceeds the fair market value of your total assets—at the time you reach a debt settlement. In addition, if forgiven debt originates from something other than a credit card agreement, different tax regulations may apply.
Overall, reaching a reasonable agreement with a creditor is still the best option available to anyone with significant credit card debt. Whether this agreement is an affordable monthly pay-down plan or a lump-sum payment, its net benefit will be positive because it will effectively eliminate the possibility that you’ll get sued for what you owe while potentially avoiding some further credit score damage. And even if you do end up having to pay taxes on forgiven debt, there’s still a bright side to which you can turn: you’re becoming debt-free without paying the full amount that you borrowed. Therefore, as long as you’re aware of the fact that forgiven debt is taxable and you live up to any resulting IRS obligation, debt settlement should be an effective means of relegating credit card debt to the past.
[Disclosure: Some of the links within this article point to CardHub.com, which is owned by the same parent company as Wallet Blog.]