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The Potentially Hidden Consequence of Debt Settlement

Posted by attorney Mark Campanella

I think that this is pretty much a universal truth to which virtually all creditors and debtors would adhere: settling a debt for less than full value is preferable to filing bankruptcy, if possible. Debtors prefer not to have to go through the stigma or financial hit that bankruptcy (at least initially) brings, while creditors would rather not deal with the possibility of their claims being discharged without any semblance of satisfaction.

Even given that reality, the determination of whether settling a debt is right for you depends entirely on your specific circumstances. Explore your options with a professional before you undertake any course of action – this is the only way to ensure you know and understand not only your options, but also the potential consequences of each offered course.

IF you choose to settle your debts, my advice is be wary! Debt settlement could cost you more than you initially thought if you go into the process uninformed. Aside from my own concerns as to whether most debtors are capable of maintaining payments until even a settled debt is satisfied, there is a secondary issue to consider. Depending on the debt your settling and the amount being forgiving by the creditor, you could well be on the hook for taxes for that settlement. Yep, you heard me right – settling any sort of debt is considered a taxable event by the Internal Revenue Service. Most consumers tend to experience these “taxable events" when settling credit card debts, but the obligation is transferable across any forgiven debt.

In the most basic of terms, if a creditor has forgiven you any debt in excess of $600, Uncle Sam will wants his fair share because he considers those forgiven amounts taxable income. Think of it this way. When tax time rolls around and a company ends up claiming a loss on its taxes from a debt that its forgiven you, the IRS is still looking to get satisfied for the revenue it otherwise would have received but for the forgiven debt. For better or worse (and it could well be the cynic in me), but the system is set up to ensure the IRS receives it revenue one way or another, even if that means it’s coming out of your pocket.

This is something that virtually no creditor fesses up to during settlement negotiations; unless you went into the process familiar with the system, the first time you will likely learn about the taxable consequences of your agreement is when you receive a form 1099-C from the creditor at year-end reflecting the “income" you’ve purportedly earned from “cancelled debt". Unless you’re financially insolvent (in which case you can petition the IRS for a waiver of your tax liability, which I wouldn’t necessarily bank on), debtors will have to satisfy this new obligation. One other thing to keep in mind – even if you do later decide to file for bankruptcy, any obligations that you’ve accrued relative to the IRS are not dischargeable, so that settlement you thought was such a good idea early on might keep coming back to haunt you down the road.

The bottom line, as has seemingly become my mantra lately, is know your rights and options before you take the leap, especially toward debt settlement. Without a doubt, debt settlement can make sense, when circumstances are right. There are other times, however, where you might be better served by considering one of a number of other options to resolve your debt. Always speak with a professional so you know and understand those options.

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