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Incredible amounts of credit card debt do require equally incredible amounts of effort to pay down. Depending upon the financial situation of the person in debt, paying down the debt is nearly impossible. Outright paying off outstanding balances doesn’t even remotely seem possible. A person paying 20.1% interest on $27,000 in credit card debt who only earns $30,000 is not exactly in a financial position to pay the cards off in three years. Others are already in such bad shape, missed payments are reaching the four-month point and threats of lawsuits are forthcoming.

Debt settlement might be the best plan for a troubled borrower. Numerous services do make debt settlement deals sound very easy. Perhaps the process is easy, but debt settlement does not come without consequences. Debt settlements does come with positives, but there are also drawbacks. Understanding the drawbacks allows anyone considering the plan to really understand what he/she is seeking to engage in.

Debt Settlement Explained

A debt settlement plan is exactly what the name described. A settlement amount is paid to close unsecured debt that is well into the collections process. Paying $3,000 to close out a $5,500 outstanding balances allows the lender to recoup money that is headed to default. The borrower gets out from all the various hassles of being trapped in debt. He/she also ends up free from the massive interest rates that drain funds and make paying off debt impossible.

Addressing the Consequences of Debt Settlement

Why are there consequences to settling a disastrous debt situation? What is wrong with undergoing a debt settlement deal? Nothing is “wrong” with settling a debt. The delineation of the debt simply changes from a loan to income. Now the income is taxable.

Settling a $5,500 debt for $3,000 means the lender has “given” the borrower $2,500. The $2,500 was already spent via making charges on the card. A credit card company cannot give away money as a nontaxable gift. Forgiven debt is logged on a 1099-C and reported to the IRS. For all intents and purposes, it is income. This is why the money ends up being taxable.

No one is going to be thrilled to pay tax on the forgiven debt, but a little accounting on the figures should bear good news. The tax rate is surely going to be lower than the interest rates the lenders are charging.

Exemptions to the Tax Rules

The vast IRS tax code is filled with many rules and regulations. Within the code’s vast pages are exemption criteria for persons with forgiven debt.

Insolvency is one area of exemption. Insolvency refers to a person whose debts way exceed his or her net assets. Someone whose net worth is negative won’t have to pay taxes on a debt settlement deal. A person whose net worth is reflected by $2,000 in a checking account and his/her debt is in the range of $20,000 would easily be deemed insolvent and nontaxable. Some of the forgiven debt may end up being taxable if it is beyond the insolvency threshold. Anything behind the dollar figure of insolvency would be taxable. A person whose negative net worth is -$2,000 and has $3,500 forgiven would have to pay tax on the $1,500 difference.

The other exemption category — in addition to a statutory exemption of mortgage debt — would be bankruptcy. Debt discharged during bankruptcy proceedings won’t come back to haunt someone at tax time.

Granted, most people seeking debt settlement wish to avoid entering into bankruptcy due to the disastrous decade-long impact bankruptcy has on a credit score. Whether one chooses to settle debt or file for bankruptcy a lot of thought should go into the making a decision.