The Debt Settlement Tax Can Bite You If You're Not Careful | Debts

The Debt Settlement Tax Can Bite You If You're Not Careful

Written by Sean Payne

Monday, 21 September 2009 13:10

by SeanPayne

If you're currently in debt and you may be thinking about negotiating with your creditors to settle your debts for less than you owe. What you may not know about debt settlement, though, is that it can have a significant impact on your taxes.

If you negotiated a settlement with your creditors, you're basically "earning" money from your debt. Here's how it works: If you took out a loan for $10,000 and couldn't pay it back, but negotiated with your creditors for them to accept $6,000 as full payment of your loan, you've pocketed $4,000 (the difference between how much you borrowed and how much you paid back). The IRS takes a close look at these kinds of loan repayments.

It's possible that at some point in the past, the U.S. tax laws allowed for this to happen with no tax implications. Unfortunately for you, the IRS is smart about such things, and has closed any loophole that may have existed in the tax law.

As in our example above, if you settle credit card debt or any other type of debt for less than you owe, you will probably be held liable for whatever "profit" you realize after settling your debt. Remember this when it's time to file your taxes after settling your debts.

Even though this debt settlement tax may sound like a bad thing, you're still better off having settled your debt, even after taxes. In our example, you've realized a $4,000 "gain", but at most you'll have to pay about 30% (depending on your tax bracket). Even after you've paid the tax, though, you still only paid $7,200 in repayment of a $10,000 debt. That's a 28% discount, and is still a huge bargain.

Since the debt settlement tax is so little-known to most people, they usually don't do anything about it until after an IRS audit. Keep it in mind, and don't let this tax take you by surprise.

If you'd like more details on how this tax applies to your specific situation, please consult with a CPA or other tax professional.

DISCLAIMER: This article is provided as information only and is not to be taken as financial advice.

Sean Payne is a personal finance enthusiast who has learned through trial and error (and a lot of advice) how to get out of debt. Discover how to avoid the debt settlement tax at Sean's website, where you'll find a unique "get out of debt course" that really works.