Have you ever gone to the emergency room and notice that months later bill after bill starts to come in? Suddenly you owe several thousand dollars medical bills. In extreme cases, it can be hundreds of thousands. Occasionally hospitals and doctors’ offices will work with you to work out payment arrangements. Alas, they often won’t.

Do you have multiple credit cards?  Have you ever missed a payment, or two, or more? Missed payments plus penalties and/or fees tend to snowball out of control. Sometimes they snowball so quickly that your entire balance is affected and practically doubles! Out of nowhere the debts you were doing your best to pay have become impossible to manage. It wasn’t until this moment that you realized just how fast a snowball becomes an avalanche.

You do your best to look for methods you can you can try to get ahead of this—but how do you get ahead of an avalanche?

You call the hospital or the credit card company to ask about Debt Settlement. The representative on the other line says they are willing to forgive half of your total balance if you pay the other half in a lump sum within a number of days. Sounds like a good deal, doesn’t it?

The truth is that whether or not it’s a good deal really depends two main things.  The first is how much you owe in total; and the second is how much money you have available to you at the time. Chances are if you are in the middle of a debt avalanche, you probably don’t have that kind of money laying around.

Even if you do have the funds to pay a lump sum, there is a catch. There’s always a catch. Often times, you will end up having to pay taxes on whatever amount is forgiven by the creditor.

The explanation for it is this: when you borrow money from a bank or a credit card, for example, you don’t have to pay taxes on that money because it’s not income. It’s money you are borrowing and intend to pay back later with your own money. However, “credit” is only considered credit, and NOT income, on the condition you pay that money back.  Consequently, as soon as a creditor “forgives” a debt, either completely or partially, that forgiven debt is now considered income. If money is considered income then you must pay taxes on it.

For Instance: let’s say you have a credit card with a $12,000 balance. You make an offer to settle it for $6,000 and that offer is accepted. You pay the $6,000 you promised, and the credit card company forgives the remaining $6,000.00 balance like they promised.

Around tax time, you will likely receive a 1099-C which tells the IRS that you had income from the credit card company. Therefore, you will end up paying taxes as if you had received an extra $6,000 worth of income that tax year.  The final kicker is that you go through all this and now the credit card company that made the deal with you will likely report your debt as “settled,” or something similar. This will ding your credit.

Debt settlement is completely different than bankruptcy and if you would like to find out more about the differences please visit our “Bankruptcy vs. Debt Settlement,” article.