Definition

• Debt settlement allows debtors to resolve delinquent debt for less than the full amount due. The Federal Trade Commission recognizes the tactic as a legitimate debt management strategy and an alternative to bankruptcy. Debt settlement is available only on unsecured debts such as credit cards. SmartMoney reports that credit card companies often will settle for 20 to 70 percent of the balance.
  
  

Considerations

• Tax consequences are a hidden cost of debt settlement. Settling a $10,000 credit card debt for $2,000 would appear to be a bargain, especially for someone simply not able to pay the full balance. However, the IRS could treat the $8,000 in savings as taxable income by requiring the 1099. By law, the IRS can treat each settled debt resulting in more than $600 in savings as income.
  
  

Timeline

• Credit card companies and debt collectors usually offer debt settlements on credit card accounts that are past due by six months or longer, although some settlements are possible sooner. Credit card companies will not extend settlement offers on accounts that are current, however. After settling an account, the creditor or debt collector will notify the IRS if savings to the debtor are for $600 or more. Taxpayers receive the 1099 forms in January of each year. However, debtors are responsible for reporting debt settlement savings even if they do not receive forms from creditors. People who fail to report debt settlement savings on their tax returns could face additional penalties from the IRS.
  
  

Timing

• People who are considering debt settlement should plan the transactions. For example, settling debts in December could result in a higher tax bill due a few months later in April. However, settling the same debts in January could gives the taxpayer until April the following year -- 15 months -- to prepare for the tax consequences.
  
  

Exemptions

• The IRS allows for some people to escape higher taxes due to debt settlement. People who are insolvent at the time of the debt settlement can ask for an exemption. Insolvency means that the taxpayer had more debts than assets at the time of the settlement. Settled debts are not treated as income if the IRS agrees that the taxpayer suffered from insolvency.