What You Need to Know About Debt Settlement

Potentially Damages Credit - Credit reports will show evidence of debt settlements and the associated FICO scores will be lowered temporarily as a result. However, if a "paid in full" letter is obtained from the creditor, the debtor's credit report should show no sign of a debt settlement. Additionally, as debtors settle their accounts, the score starts to go back up again. Credit Repair could be a good way to go after the program to rebuild your credit score.

Potential for Lawsuits - Though few creditors wish to push borrowers toward bankruptcy, and the potential of governmental protection against all debts), there’s always the possibility of a lawsuit (while rare) whenever debts remain unpaid for a long period of time. In the debt settlement process, the debtor's accounts remain in default. While the debts are still in default the creditor or its assignee can still file a lawsuit.

Eligibility of Debts - The specific types of debt themselves affect the success of negotiations. Tax Liens and domestic judgments remain unaffected by attempts at settlement. Student loans, even those not federally subsidized, have been granted special powers by recent legislation to attach bank accounts without possibility of Chapter 7 bankruptcy protection. Also, some individual creditors, including Discover Card & Citibank, for example, tend to have an aggressive resistance against negotiations.

Tax Consequences - Another common objection to debt settlement is that debtors whose debts are partially canceled outside the bankruptcy system will need to report the canceled portion of the debt as taxable income. (IRS Publication Form 982) The IRS considers $600 or more of forgiven debt as taxable income.[1] The forgiving creditor must provide the taxpayer with a 1099-C tax form. This form will list the amount of forgiven debt and interest in Box 2. Taxpayers with portions of personal loans forgiven may not subtract the interest reported in Box 3 from the amount of reportable income on this form. While this does not guarantee you will have to repay taxes on forgiven debt, it is a possibility. Please speak to your CPA about potential tax consequences on forgiven debt as it relates directly to you, not all consumers pay taxes.

The IRS does not require taxpayers to report forgiven debt if the tax payer was insolvent at the time the creditor forgave the debt. Being insolvent means that the amount of debts are greater than the amount of assets (how much money and property the debtor owns). However, the IRS adds that “you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent.”[2]

For example, if a taxpayer is $10,000 in debt and owns $3,000 in assets, he/she cannot exclude more than $7,000 of forgiven debt from his/her income tax. Any forgiven debt over $7,000 that year must be reported as taxable income.