Drawbacks of Debt Settlement - Potential Tax Implications

(The following is for education purposes only and not tax advice. To learn more about how the tax implications of debt settlement will affect your individual situation, please consult a CPA or attorney licensed in these matters).

The final frequently cited drawback of debt settlement is the possibility of tax consequences from settling your debt. The IRS mandates that consumers report on the income tax returns the portion of any debts $600 and over that are canceled outside of bankruptcy. In other words, if a $10,000 debt is settled for $4,000, the IRS expects consumers to report the forgiven portion, $6,000, on your tax return. For some consumers this may cut into the overall savings from debt settlement, which is a definite disadvantage. However, like most of the drawbacks of debt settlement, they must be put into proper context in order to weigh how this will affect your situation:

1. The IRS does not require taxpayers to pay taxes on settled debts if they were insolvent at the time the debt was forgiven. The IRS defines insolvency as a financial state where one’s liabilities (debts) are greater than one’s assets (equity in property and money in his or her name). Needless to say, many consumers who are considering debt settlement are insolvent, but to determine whether you are, you may want to consult an accountant or someone licensed in tax matters. If you are considered insolvent, however, the IRS allows to “exclude any amount of canceled debt that is more than the amount by which you are insolvent.”

2. Your overall savings can still be quite significant even with the tax implications. After all, you are taxed a percentage of the savings, not the overall debt amount. When you factor in any savings from the interest charges, the money you save from debt settlement is even more dramatic.

Follow this link to discover some other potential disadvantages of debt settlement.