Debt settlement has become a popular way to resolve the debts without filing bankruptcy. With this approach, creditors agree to receive a portion of what you owe (usually around 50% or less) to settle the account and the balance is forgiven. This technique will certainly continue to grow in popularity now that the new bankruptcy law makes it difficult to fully discharge debts in a Chapter 7 bankruptcy.

As with everything, there is no free lunch, and creditors are required to report debts to the IRS on Form 1099 (when the set balance is $ 600 or more). Therefore, the possibility exists that you may owe taxes on the forgiven part of the blame. For this reason, many financial writers and debt counselors are strongly critical of debt, to the point where they actually recommend against it just because you can end up owing taxes. But the tax consequences of settling your debts is strongly emphasized enough, and this is really just a minor issue at best.

First, even if you end up owing taxes on balance, it is because you have saved a lot of money on your original debt. The sum of what you paid creditor, plus taxes, will still be much less than what you owed to begin with. There is still a net savings. So it is difficult to understand why this is seen as a problem in the first place!

Second, the vast majority of people who settle their debts do not have to pay tax on the forgiven part of the balance. It is because of "insolvency" rule, described in IRS Publication 908, "Bankruptcy Tax Guide." Do not let the title fool you. You need not have submitted a formal application for bankruptcy to take advantage of the insolvency rule.