Settling your debt may incur some tax liabilities

Many Americans have run up thousands and even tens of thousands of dollars in credit card debt. It may seem impossible, but there are people who have actually managed to amass $100,000 in credit card debt alone. There are a number of factors that make this possible, including:

• Credit card companies that send out billions of preapproved applications per year to just about everyone
• Consumers who don’t pay attention to how much they spend or given any thought to how they will repay their obligations
• Interest and penalty fees that cause the principal of the balance to grow tremendously
• Historically low minimum payment amounts that do nothing to reduce the amount of the balance

These factors, and others, have helped Americans gather a record amount of debt. Many people are working through the problems and are trying to get out any way they can. Some are using debt consolidation, others are taking out more than one job to make ends meet and others are giving up and filing for bankruptcy.  There is another option that sometimes works - debt settlement.

With debt settlement, you negotiate an amount with your creditors and they agree to settle for less than the total that you owe in exchange for a lesser amount to be paid in full immediately. For some debtors, this represents an ideal solution. They avoid bankruptcy and the years of harm to their credit score that comes with such a filing. There is a downside to settling a debt that many don’t foresee, however. That downside is an income tax liability.

Many people with debt problems fail to realize that debt which creditors forgive is treated by the Internal Revenue Service as taxable income to the consumer who has the debt forgiven. If you owe $50,000 and your creditor agrees to settle for $30,000, the $20,000 worth of forgiven debt is treated by the IRS as income. If you earn $35,000 and have $20,000 in forgiven debt, you owe income tax on $55,000 in taxable earnings. This comes as a huge shock to many consumers, who simply don’t see it coming. If you are in a 28% tax bracket, that $20,000 in outstanding bills amounts to $5600 in additional income tax that will be due in April.

Not all forgiven obligations are taxable. Some student loans and farm obliations are not taxable under certain circumstances. Consumers who have some or all of their bills forgiven would be wise to consult with a professional tax preparer in order to make sure that their finances and tax payments are handled properly.

Getting out of financial trouble is great, no matter how you do it. The least attractive way of doing it is to file for bankruptcy, as that can hurt you for up to ten years. If you cannot pay in full, you may be able to get your creditors to settle with you. Just be aware that doing so may cost you more money at tax time.

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