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Debt Settlement and the IRS

Before you begin the debt settlement process, be certain you understand how the IRS views any debt reduction you obtain from a creditor.

What You Gain From Debt Settlement

When debt becomes overwhelming, you are stressed, anxious, and less productive. Creditors are calling, you cannot sleep well and you are leaving yourself vulnerable to a host of physical ailments as well. It is definitely time to look at your options for relief, and debt settlement can be a reasonable and less painful way out of your troubles.

Debt settlement involves contacting creditors and negotiating a lower overall debt amount. If you cannot make the lower agreed upon amount in one payment, you will also need to negotiate a payment plan until the debt is paid. Normally, you may need to go through a debt settlement professional in order to negotiate a payment plan, although many individuals have been able to successfully negotiate these on their own. If you are assertive and have the skills, the negotiation can probably be accomplished without involving others. If you are timid and easily swayed, get a professional and pay the extra fees usually involved.

The other issue involved in debt settlement is the “hit” your credit rating takes when debt is settled for less than the original amount. You will always take a hit when the debt is turned over to a collection agency, but how the settlement is reported to the credit bureaus can affect further hits. Be certain that the negotiated settlement includes reporting of “paid” or “settled.” More and more, creditors are unwilling to report “paid as agreed” on settled debt, but it is far worse to get “charged off” reported. Be certain you know exactly how the settlement will be reported.

How the IRS Gets Involved

The IRS considers the amount of reduction of original debt as income, if it is over $600.00. If a debtor has a $3000 debt that is settled for $1500, for example, $1500 is considered income for that tax year, and must be added to total income on the tax return. This will increase an individual’s tax bill or reduce a refund, dependent upon income bracket and other deductions.

There is a little known part of this tax law, however, about which any debtor should be aware. A debtor does not have to claim as income any amount of debt reduction which exceeds the total assets of the debtor. For example, if a debtor has $15000 worth of debt which was settled for $7500, the total reduction amount is $7500. If the total assets of the debtor are a car worth $3000, then $4500 can be excluded from the taxable debt reduction amount. Thus, the taxpayer only has to report debt reduction “income” of $3000. This can be very important if the taxpayer has few assets and a large debt reduction amount.

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