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The Negative Side of Debt Negotiation

While you can get out of paying hundreds or even thousands of dollars in debt that you legitimately owe, the major catch is that you might be required to come up with a big sum of money to pay the creditor in order to settle the debt.  Most creditors and collectors will want a lump sum payment or several lump sum payments and will frown upon (but will accept) an extended monthly payment plan. This means you must either borrow money from friends or relatives, sell some collateral, etc., to come up with enough money to pay the creditor off fast.   Most people in this situation are flat broke and just don't have the cash to negotiate.

There is no turning back!  Once you inform an unsecured creditor that you can't pay your debt and you're thinking about filing bankruptcy, you can't take it back.  Your relationship with this creditor is ruined, even if you keep your account current. This is significant when dealing with credit card companies and other revolving credit accounts.  Once you inform a credit card company that you are thinking about filing bankruptcy, you can be sure that they will immediately cancel your remaining credit line, even if you've never missed a payment.  They might even increase your interest rate dramatically if they determine you are now a high risk customer -- you could go from a respectable 13% APR to a 24% APR overnight!  For this reason, you should only try debt negotiation when you really are on the verge of filing bankruptcy and have no choice but to try and work out some alternate payment arrangement with your creditors.  You should also assume that your credit cards will no longer be available for use.  Before you reveal to your creditors that you're deep in financial trouble, assume that you will no longer be able to use these credit cards.  Can you live without them?

There might be tax consequences.  The IRS considers forgiven debt of $600 or more to be income in certain circumstances.  Certain creditors that forgive debt of $600 or more are required to report this to the IRS.  In most situations, you will not have to pay taxes on forgiven debt; however, you do need to read the column at right and visit the IRS website (www.irs.gov) and do some research to find out what your individual tax consequences will be.

Generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. You have no income from the canceled debt if it is intended as a gift to you. A debt includes any indebtedness for which you are liable or which attaches to property you hold.

If a federal government agency, financial institution, or credit union cancels or forgives a debt you owe of $600 or more, you will receive a Form 1099-C, Cancellation of Debt from them.  Your creditor is required by law to report whatever debt it has forgiven you in excess of $600 to the IRS.

Whether or not you must include the interest portion of the canceled debt in your income depends on whether the interest would be deductible if you paid it. If the interest would not be deductible (such as interest on a personal loan), include in your income. If the interest would be deductible (such as on a business loan), include in your income the net amount of the canceled debt.

There are several exceptions to the inclusion of canceled debt in income.

Nonrecourse debt:  If you are not personally liable for the debt (nonrecourse debt), different rules apply. You may have a gain or loss if nonrecourse debt is canceled or forgiven in conjunction with the foreclosure or repossession of property to which the debt attaches. See IRS Publication 544 for more information.

Deductible debt:  You do not have income from the cancellation of a debt if your payment of the debt would be deductible. This exception applies only if you use the cash method of accounting. For more information, see chapter 5 of IRS Publication 334, Tax Guide for Small Business.

Price reduced after purchase:  Generally, if the seller reduces the amount of debt you owe for property you purchased, you do not have income from the reduction. The reduction of the debt is treated as a purchase price adjustment and reduces your basis in the property.

Do not include a canceled debt in your gross income in the following situations:  (1) the debt is canceled in a bankruptcy case under title 11 of the U.S. Code. See IRS Publication 908, Bankruptcy Tax Guide; (2) the debt is canceled when you are insolvent. However, you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent. See IRS Publication 908; (3) the debt is qualified farm debt and is canceled by a qualified person. See chapter 4 of IRS Publication 225, Farmer's Tax Guide; or (4) the debt is qualified real property business debt. See chapter 5 of IRS Publication 334.

Your Credit Rating Will Suffer. Reduced settlements -- If a collector accepts a reduced settlement from you, a notation that you have settled the account for less than the full balance will likely be placed on your credit report.  The original creditor has the right to insert a charge-off notation for the amount of debt that is forgiven.  A charge-off notation on a credit report will significantly damage your credit rating and your ability to obtain financing at a reasonable rate for about the next three to five years.  However, most creditors will not insert a charge-off notation.  Instead, they will likely insert a notation on your credit report similar to the phrase, "Settled for less than amount owed."  This is also a negative notation and will damage your credit rating, but not to the extent that a bankruptcy or charge-off notation will.

Of course, by the time your account has been turned over to a bill collector, your credit report is so damaged that a few more bad notations isn't going to damage it anymore than it already is.  (Once your credit score is below 600, it doesn't matter if its 300 or 500 -- no one is going to give you credit.)

You will also damage your credit rating by asking for a new payment agreement with your creditors.  This is true if you do the negotiating yourself or you let a credit counseling service do it for you. Many credit counseling services claim in their advertising that signing up with them will improve your credit rating, but this is an outright lie.  Some of them claim that they can get creditors to remove late payment notations and such, but they will almost certainly be replaced with a notation indicating that you are in a hardship program.  It might read something like, "Alternate repayment plan."  Such a notation will damage your credit rating just as severely as a late payment notation, but not as badly as a bankruptcy.   Negative notations typically remain on your credit file for up to seven years. 

Risk of Litigation.  Your negotiating efforts might fail and you find yourself being sued, property seized or your wages garnished.  It is important to assess your risk of being sued before you begin negotiating.

Next Topic:  What are Your Odds of Being Sued?
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