Some of the negative consequences of debt settlement are well publicized – damage to your credit score, high fees to debt settlement firms, and taxes owed to the IRS. But, you should not really rule out debt settlement until you educate yourself about each of these consequences.
Your Credit Score
It’s true, debt settlement will likely hurt your credit score, but the alternatives also may have an effect on your credit. Bankruptcy may significantly decrease your credit score. Credit counseling can keep you from getting new credit. Debt consolidation could raise your credit utilization. If you’re already behind on your payments when you decide to go with debt settlement, your credit has probably already been hurt by the missed payments.
Also, credit score damage doesn’t have to last forever. Once you’re finished settling all your debts, you could start rebuilding your credit. Take the right steps and it might not be long until your credit score is increasing and you’re getting offers for better credit and higher limits.
Debt Settlement Fees
Thanks to a recently amended law, many debt settlement companies are prohibited from charging upfront fees. Instead, these companies can only charge a fee for their services when they actually settle a debt, such settlement is memorialized in writing and a payment has been made to the creditor. Even then, they can only charge a fee for that debt, not for all the debts you have enrolled unless the requirements above have been met for those debts as well.
Some companies are exempt from the amended laws by meeting with clients in person since the law primarily applies to for-profit companies who sign up customers over the phone. But, if you’re worried about being taken advantage of, do-it-yourself debt settlement is an option. Debt settlement is mostly about negotiation, no special relationships or training are necessary but they could be helpful.
Taxes on Settlements
When you settle a debt for less what you really owe, the creditor has cancelled the remaining part of the debt. The good news for businesses is that they can write this amount off on their taxes. The bad news for you is that you’re required to include these amounts on your tax return. If the cancelled debt is $600 or more, the creditor must send a form to the IRS letting them know they’ve cancelled this debt. The IRS, in turn, will be expecting you to include this on your tax return. Their automatic return checking systems can verify that you’ve included this income.
There is a way you do not have to include certain cancelled debts on your income. To the extent you are insolvent at the time the debt is cancelled, you don’t have to report it as income. Insolvent means that your debts were greater than your income. Whenever you have a debt cancelled, you should calculate your net worth at that time, so you have a record that you were indeed solvent when the debt was cancelled. You’ll need to file IRS Form 982 to claim an insolvency exemption for cancelled debts. If you’ve hired a tax preparer, make sure you mention the form and the insolvency exemption to avoid overpaying your taxes.
Dealing With The Drawbacks
As you see, there are ways to mitigate the negative consequences of debt settlement. These consequences don’t have to necessarily keep you from pursuing debt settlement if that may be the best thing for your debt.