Doing a Debt Settlement in 2022? Prepare for This Unwanted Surprise

Be careful not to get caught off guard.

Being in debt can be extremely stressful. Between calls from creditors nagging you to pay and the constant knowledge that you owe a bunch of money, debt could have a seriously negative impact on not just your finances, but your quality of life.

If your debt has reached the point where it's become unmanageable, it may be time to look into doing a debt settlement. With a debt settlement, a creditor -- whether it's a medical office, a credit card company, or another lender -- agrees to accept an amount that's less than what you owe. If you owe $2,000 on a loan, a lender might agree to accept a $1,200 payment and write off the rest. Once you pay that $1,200, you won't owe that lender any more money.

If you're wondering why any given creditor might agree to a debt settlement, it's simple. That way, they get some amount of money rather than run the risk of having to keep chasing you down to potentially get none.

You can work out a debt settlement agreement on your own or with the help of a debt settlement company or lawyer. But going this route has consequences.

Any time you do a debt settlement, it shows up on your credit report. And it can then serve as a major red flag to lenders.

Imagine you want to take out a personal loan and have a recent debt settlement on your record. A lender might hesitate to let you borrow money after seeing your last lender didn't get repaid in full.

But while a debt settlement might serve as a black mark on your credit report and lower your credit score, there's another costly repercussion you might face.

A new tax liability

When you do a debt settlement, the amount of your debt that's written off is generally reported to the IRS. And it's generally considered taxable income. If you do a debt settlement this year, you may end up owing the IRS money next year when you file your 2022 tax return.

Say you owe a lender $2,000 and settle your debt for $1,200. At that point, you may be liable for taxes on the $800 that your lender writes off. You'll need to list that $800 as income on your tax return, and it may result in a higher tax bill for you.

Now this isn't to say that you'll automatically owe the IRS money because of settled debt. Let's imagine your $800 write-off results in a $200 tax bill. If the IRS owes you $500 in the form of a refund, you won't have to write out a check. Rather, you'll just get a smaller refund.

The point, however, is that debt amounts written off are usually considered taxable income. And that's something you'll need to prepare for.

What if you can't pay the IRS?

You may run into a situation where you owe the IRS money due to a debt settlement. If that's the case and you can't cover that tax debt in full, you can ask the IRS to put you on an installment plan where you pay it off over time.

But don't just blow off your tax obligation. If the IRS doesn't get paid, it could come after your wages, and that's not a scenario you want.