How Debt Relief Affects Your Credit and Taxes

Debt settlement can lower the amount you owe, but it has two costs that are easy to underestimate: damage to your credit and a possible tax bill on the debt that is forgiven. This guide explains both so you can weigh them before you enroll.

We are not tax advisers and this is general information, not advice for your situation. Talk to a tax professional about the tax effects and check your own credit reports for the details that matter to you.

Why debt settlement hurts your credit

Most settlement programs ask you to stop paying the debts you enroll and save into a dedicated account instead. Creditors are more willing to negotiate once an account is behind. That design is what does the damage.

Here is what typically shows up on your credit report:

1. Late payments. Each month you skip, the creditor can report the account as 30, 60, 90 days late and beyond. Payment history is the biggest factor in most credit scores.
2. Charge-off. After several months of missed payments, creditors often charge the account off and may sell it to a collection agency, which can add a collection account to your report.
3. Settled status. When the debt is settled, the account is usually updated to show it was paid or settled for less than the full balance. That is better than an unpaid charge-off, but lenders still see it as a negative.

Settlement companies say this plainly in their own disclosures. ClearOne Advantage says entering a settlement program could adversely affect your credit score, and JG Wentworth Debt Relief warns that failing to pay creditors will likely hurt your creditworthiness and may lead to collections or lawsuits.

How much and for how long

How far your score drops depends on where it started and what else is on your report. People with high scores and clean histories usually see bigger drops than people whose scores already reflect missed payments.

Late payments, charge-offs and collection accounts generally remain on your credit report for up to seven years from the date the account first went delinquent. The impact on your score tends to lessen as the marks age and as you add positive history.

While you are in the program, other effects are common:

• New credit applications are likely to be declined or priced high.
• Card issuers may close enrolled accounts, which can raise your credit utilization.
• Creditors may add late fees and interest, so balances grow until they are settled.
• Some creditors may sue. A court judgment can lead to wage garnishment or a bank levy in many states.

How the alternatives compare on credit

• Debt management plan. Your accounts stay current, so the impact is usually milder. Closing enrolled cards can raise your utilization for a while.
• Debt consolidation loan. A hard inquiry and a new account cause a small, temporary dip. On-time payments then build positive history. See our personal loan rankings.
• Bankruptcy. A Chapter 7 filing can stay on your report for up to ten years and Chapter 13 for up to seven. It is severe, but it can resolve debts faster and stop lawsuits.

Our guide to debt relief vs consolidation vs credit counseling compares them in full.

Is forgiven debt taxable?

Generally, yes. When a creditor agrees to accept less than you owe, the IRS generally treats the forgiven part as income, called cancellation of debt income. You report it on your tax return for the year the debt was cancelled.

Settlement companies flag this too. National Debt Relief and Pacific Debt Relief both tell clients to talk to a tax professional about the tax consequences of settling for less than the full balance.

Form 1099-C

When a creditor cancels a debt above an IRS reporting threshold, it generally must send you and the IRS a Form 1099-C showing the amount cancelled. You may get several, one from each creditor, possibly in different tax years if settlements happen over a long program.

Even if you do not receive a form, the forgiven amount can still be taxable. Keep every settlement letter and a record of what you paid.

A hypothetical example

This is a hypothetical example only. Suppose a creditor settles a hypothetical $8,000 balance for a hypothetical $4,000. The hypothetical $4,000 forgiven could count as income for that year. Depending on your tax bracket, that could add a meaningful amount to your tax bill, which should be part of your savings math from the start.

The insolvency exclusion

You may be able to exclude some or all cancelled debt from income if you were insolvent immediately before the cancellation. Insolvent means your total liabilities were greater than the fair market value of all your assets. The exclusion is limited to the amount by which you were insolvent.

You claim it on IRS Form 982, attached to your return. Many people in settlement programs are insolvent, but you have to do the calculation and keep records. A tax professional can help.

Other exclusions exist, for example for debts discharged in bankruptcy, but they rarely apply to a typical card settlement.

State taxes

Your state may also treat cancelled debt as income. Rules vary, so check with a tax professional or your state's tax agency.

How to plan before you enroll

• Pull your credit reports from all three bureaus so you know your starting point.
• Ask the settlement company to explain, in writing, how it expects your credit to be affected and how it handles creditors that sue.
• Estimate the tax. Set aside money from your savings for a possible tax bill, or check whether you are likely to be insolvent.
• Keep records of every settlement agreement, payment and 1099-C.
• Consider timing. Big purchases that need credit, like a car or home, are harder during and soon after a program.

Rebuilding after settlement

Your credit can recover. Steps that usually help:

1. Pay every remaining bill on time, every month.
2. Keep card balances low relative to your limits.
3. Use a secured card or a credit-builder loan if you have no active accounts.
4. Check your reports after each settlement to make sure the account shows as settled with a zero balance, and dispute errors with the bureau.
5. Avoid taking on new debt you cannot repay.

The bottom line

Debt settlement trades credit damage and a possible tax bill for a lower payoff. For some people that trade is worth it, especially if they are already behind. For others, a debt management plan, a consolidation loan or bankruptcy is less costly overall. Compare the options, read our guide to how debt settlement works and what it costs, and see our debt relief rankings before you choose a company.