Debt Settlement and My Taxes

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At first glance debt settlement may seem like one of those areas where you can “have your cake and eat it too.” Let’s face it: if you owe $6,000 on a credit card, and the company offers to forgive half of the sum, that seems like a pretty good deal! However, the down side of debt settlement is not necessarily as obvious. Perhaps the largest problem with debt settlement is that it can have an effect on your taxes.

How Can Debt Settlement Affect My Taxes?
When an amount of money is “forgiven” in debt settlement that money is often considered taxable. This means that when April 16th rolls around you will be responsible for reporting the settled amount and for paying taxes on it. This may not seem like a problem at the time of settlement, if you are driven by the desire to get out of debt. However, down the road you may be distressed at the decision to settle if you are unprepared for the tax responsibility.

In some cases the taxes you have to pay on forgiven monies from debt collectors can cause a financial hardship come tax time. This is particularly a problem if a large amount of money has been negotiated upon. Debt collectors who offer debt settlement may or may not disclose the information that you will have to pay taxes on the money settled. And if the leap in your tax bracket comes as a surprise it may be difficult to come up with the needed money to pay taxes. This will obviously only compound preexisting financial problems.

Will I Pay Taxes if I am Insolvent?
However, in many cases, people who are in such dire financial circumstances that they are offered debt settlement don’t end up paying taxes at all. How, you may ask? Basically, it boils down to the person being “insolvent,” or having a negative net worth. If you owe more than you own you don’t have to pay taxes, regardless of the generosity of debt collectors. This ends up working out very nicely, then, for seekers of debt settlement. If you are forgiven your debt, plus you don’t have to pay taxes on it you may as well have been handed a “get out of jail free” card.

Obviously, taxes are something to think about as you consider debt settlement. Talk with your financial counselor and weigh your options. The desire to get out of debt may be strong, but before you make a decision, have a plan.

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