Debt Settlement vs. Bankruptcy: the Tax Consequences

In these harsh economic times, many people are finding themselves struggling to make ends meet. No matter how persistent or resourceful they are, some people will find themselves in the difficult position of having to radically restructure their finances because they suffer from unmanageable debt. There are two basic options for dealing with overwhelming debt. You can either declare bankruptcy or you can seek to settle the debts directly with the creditors. Both options have their upsides and downsides, and it is not always easy to decide which option is best for you. You should discuss your situation with an experienced Morris County bankruptcy lawyer to make sure you find the best debt relief mechanism for you.

Debt settlement refers to a debt reduction process where the debtor reaches an agreement with the creditors to forgive a percentage of the debt in exchange for completely paying a portion of the total amount. They do not like to advertise it, but credit card companies would rather have you pay off half your debt than none of it. An attorney or third party company will negotiate on your behalf with your creditors, but they charge a fee for their efforts on your behalf. Debt settlement might be appealing because the alternative of declaring bankruptcy can seem like a drastic measure, but there are several drawbacks to the process.

The tax consequence for using debt settlement is the biggest drawback to this method. Unlike debts cancelled through the bankruptcy process, debts discharged through a negotiated settlement are eligible for taxation. The Internal Revenue Service considers any forgiven balance that exceeds $600 as taxable income. That means that the higher the balance that you settle with the creditor, the higher the amount you will have to declare on your tax return. For people trying to get back on firm financial footing, the potential tax consequences can be devastating. The taxes are likely to be just as damaging to your financial security as the original debt. If your tax rate is 15 percent and you manage to settle $7,000 of forgiven debt, you will receive a $1,050 tax liability for that year.

Filing for bankruptcy under either Chapter 7 or Chapter 13, does not carry a tax penalty. There are no extra tax ramifications for settling your debts through the bankruptcy process, so it is often easier to maintain financial equilibrium, and the total amounts forgiven tend to be higher for that reason. Negotiated settlement may be attractive to a narrow range of individuals, but the lack of tax consequences makes bankruptcy a better option for most people suffering from unmanageable debt.

If you are thinking about debt settlement but are wondering if bankruptcy is a better choice, contact an experienced Morris County Bankruptcy attorney to explore your options.

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