Being in debt may be a very stressful situation. Between the repeated reminders from creditors to pay and the continual awareness that you owe money, debt may have a major detrimental influence on not only your finances but also your quality of life.
If your debt has grown overwhelming, it may be time to consider debt settlement. A debt settlement agreement is reached when a creditor – whether a medical office, a credit card company or another lender – agrees to take a sum less than what you owe. If you owe $2,000 on a loan, the lender may agree to accept a payment of $1,200 and write off the remaining balance. Once you’ve paid that $1,200, you’re done with that loan.
If you’re asking why any creditor would agree to a debt settlement, the answer is straightforward. In this manner, they obtain some money rather than risk having to pursue you indefinitely in order to obtain none.
A debt settlement agreement can be negotiated on your own or with the assistance of a debt settlement firm or lawyer. However, taking this path has implications.
Any time you enter into a debt settlement agreement, it will appear on your credit record. And this can serve as a significant red flag to lenders.
Consider applying for a personal loan with a recent debt settlement on your record. A lender may be hesitant to offer you money if they find that your previous lender was not fully repaid.
However, while a debt settlement may result in a black record on your credit report and a decrease in your credit score, there is another potentially costly consequence.
A New Tax Obligation
When you settle a debt, the amount of debt forgiven is normally reported to the IRS. Additionally, it is often regarded as taxable income. If you settle your debts this year, you risk owing the IRS money when you file your 2022 tax return.
As an example, suppose you owe a lender $2,000 and settle the obligation for $1,200. At that point, you may be responsible for taxes on the $800 written off by your lender. You must report the $800 as income on your tax return, which may result in a greater tax bill.
This is not to mean that you will automatically owe money to the IRS due to resolved debt. Assume that your $800 tax deduction results in a $200 tax bill. If the IRS owes you $500 as a refund, you will not be required to send a check. Rather of that, you will receive a reduced refund.
However, the issue is that debt forgiveness is typically treated as taxable income. And that is something for which you must prepare.
What Happens if You Are Unable to Pay the IRS?
You may find yourself in a position where you owe the IRS money as a result of a debt settlement. If that is the case and you are unable to pay your tax bill in full, you may petition the IRS for an instalment plan in which you pay it off over time.
However, do not ignore your tax obligations. If the IRS is not paid, it has the right to garnish your pay, which is not a situation you want.
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