If a Debt Settlement Sounds Good to You, Wait - Until You Learn About its Tax Consequences

Richard Fonfrias, J.D.
Chicago's Financial Rescue & Bankruptcy Lawyer
Fonfrias Law Group, LLC

Most people want to pay their bills and earn a good credit score.

In fact, people are usually so eager to pay their debts that they overlook other problems that could arise.

So while paying your obligations is noble and usually the right thing to do, you should know that IRS watches bankruptcies and debt settlements closely. Why? Because they are looking for every opportunity to slap you with a big tax bill.

When you consider settling your debts, you should realize that the amount of money the creditor receives from you may not be all that you owe to settle this debt.

There's more paperwork: The IRS requires creditors to issue a form 1099-C for any amounts they forgive or settle that are over $600. And if you receive a 1099-C after paying the amount you agreed to, then on your next tax return you must treat that amount as income.

Here's an example: If you have a $20,000 debt and the creditor agrees to settle it for $12,000, the creditor will issue a 1099-C for $8,000. Then you must show that $8,000 as income on your next tax return and pay taxes on that $8,000.

So while it's cheaper to pay the tax on $8,000 than to pay the $8,000 itself, you need to take into account this added obligation, knowing that IRS may come calling.

Most debt buyers purchase accounts that are for less than $10,000. So the amount may be small enough that paying additional taxes may still make it a good deal. However, if a debt buyer is suing you for a large amount, you might be required to pay a huge tax bill. And you need to take this into account when negotiating your settlement.