Make a debt settlement in 2022? Prepare for that unwanted surprise

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Be careful not to be caught off guard.

Key points

  • When your debts become overwhelming, settling them is a solution worth pursuing.
  • But getting a debt settlement could impact your taxes, so it’s important to know what to expect.

Being in debt can be extremely stressful. Between calls from creditors urging you to pay and constantly knowing that you owe a lot of money, debt could have a very negative impact not only on your finances, but also on your quality of life.

If your debt has reached the point where it has become unmanageable, it may be time to consider debt settlement. With a debt settlement, a creditor – whether it is a doctor’s office, a credit card company or another lender – agrees to accept less than what you owe. If you owe $2,000 on a loan, a lender might accept a payment of $1,200 and write off the rest. Once you pay that $1,200, you won’t owe that lender any more money.

If you’re wondering why a particular creditor might agree to a debt settlement, it’s simple. This way they get some amount of money rather than running the risk of having to keep chasing you for not getting any.

You can enter into a debt settlement agreement on your own or with the help of a debt settlement company or a lawyer. But going this route has consequences.

Every time you make a debt settlement, it shows up on your credit report. And that can then serve as a major red flag for lenders.

Imagine you want to take out a personal loan and you have a recent debt settlement on your file. A lender might be hesitant to let you borrow money after seeing that your last lender hasn’t been repaid in full.

But while a debt settlement can put a black mark on your credit report and lower your credit score, you could be faced with another costly repercussion.

A new tax obligation

When you make a debt settlement, the amount of your debt that is written off is usually reported to the IRS. And it’s generally considered taxable income. If you make a debt settlement this year, you could end up owing money to the IRS next year when you file your 2022 tax return.

Let’s say you owe a lender $2,000 and settle your debt for $1,200. At this point, you may owe taxes on the $800 that your lender writes off. You’ll need to report that $800 as income on your tax return, and it may result in a higher tax bill for you.

This does not mean that you will automatically owe money to the IRS because of a settled debt. Let’s say your write-off of $800 results in a tax bill of $200. If the IRS owes you $500 as a refund, you won’t have to write a check. Instead, you’ll just get a smaller refund.

The point, however, is that debt amounts written off are generally considered taxable income. And that’s something you’ll have to prepare for.

What if you can’t pay the IRS?

You may come across a situation where you owe the IRS money due to a debt settlement. If that’s the case and you can’t fully cover that tax debt, you can ask the IRS to put you on an installment plan where you pay it off over time.

But don’t just get rid of your tax liability. If the IRS doesn’t get paid, it could come after your paycheck, and that’s not a scenario you want.

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