One of the things that perplexes people is what happens when a debt is settled. For those who don’t know, a debt settlement is any amount that is negotiated between you (or on your behalf) and your creditor that is less than the amount owed. Once this negotiated amount is paid, the debt is considered cleared and settled.
When this happens there is typically a tax consequence that follows. Let’s take a look at an example of what happens. Allen has a credit card balance of $45,000.00. Allen realizes that he is swamped in debt and negotiates with the credit card company to pay them $10,000.00 to settle the account. The credit card company agrees to take the $10,000.00 and clear the debt.
At the end of the year, Allen should receive a Form 1099-C which will show an amount of $35,000.00 in “Box 2” (amount of debt discharged). Under most circumstances, Allen will add the $35,000.00 to his tax return as income. There may be some insolvency or bankruptcy related issues that can reduce this amount so you should speak with your tax advisor.
The next question is, “Does settling a debt do harm to your credit score”. The short answer is “no” but that “no” is loaded. More than likely if you settle a debt, you have had trouble paying the debt in a timely fashion or you’ve had a difficult time reducing the debt utilization number. In either case, your credit score has probably taken a beating, so the settlement didn’t cause the damage, but the debt itself caused the damage.