1. Why You Don't Have to Pay Taxes for a Debt Consolidation Loan

Why You Don't Have to Pay Taxes for a Debt Consolidation Loan

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Written by: Chad Zollinger | Best Company Editorial Team

Last Updated: July 9th, 2020

You're in debt — you don't want to spend more money than needed.
 
Unfortunately, some debt relief options, like debt settlement, have tax consequences. Debt consolidation loans are an entirely different matter.
 
Luckily, a few debt relief solutions do not require extra tax payment. A debt consolidation loan is one of those tax-free debt relief solutions.
 
Paying taxes after receiving debt relief is brutal, and that’s on top of the consequence for a damaged credit score.
 
So, why are most debt relief solutions taxable in the first place?
 
Once you finish this article, you’ll be able to tell the difference between taxable and non-taxable debt relief solutions.
 
You’ll even be able to remove the “settled” debt status from your credit report.

Understanding Debt Consolidation Loans

Debt consolidation is the process of combining all your debt payments into one lump sum. A debt consolidation loan is a loan which replaces all your various debts and instead gives you one debt, one payment, and one interest rate.
 
In other words, a debt consolidation loan is a personal loan designed specifically to eliminate widespread debt.

Why Debt Settlement Is Taxable

Three categories of debt qualify as taxable income:
  1. Canceled debt
  2. Forgiven debt
  3. Discharged debt
What’s the difference between canceled debt, forgiven debt, and discharged debt?
 
Forgiven debt is the total amount of debt that you have waived by virtue of debt negotiation with creditors. Your creditors have complete control over how much — and even if — debt is forgiven.
 
Cancellation of debt, or COD, is just another optional term for forgiven debt that creditors can put on your credit report.
 
You should know that which term is put on your credit report is totally up to the creditor. This will be incredibly important when we cover how to get “settled debt” removed from your credit report later in this article.
 
Discharged debt is usually a term applied to those who file Chapter 7 bankruptcy. It means that the debtor is no longer liable for owed debts and the creditors of discharged debts are no longer allowed to pursue collections against the debtor.
 
The discharged debt status is the reason creditors would rather negotiate debt with debtors — it’s better to get something than nothing at all.
 
The bad news about settled debts? Creditors usually aren’t too happy about negotiating debt. For that reason, they usually end up putting “settled” or “canceled” on the debtor’s credit report.
 
It’s a tactic used by creditors to dissuade debtors from defaulting to debt negotiation. You can imagine how much money lenders would lose if everyone were allowed to negotiate debt with zero consequence.
 
The good news? You can ensure that settled debt doesn’t show up on your credit report. And it all happens during debt negotiations.

Debt Consolidation vs. Debt Settlement

It’s true that forgiven debt through debt settlement is taxable by the IRS, but this isn’t to be confused with consolidation loans. Technically, consolidation loans alter the interest rates on your debt instead of negotiating the actual debt amount.
 
On the other hand, debt settlement seeks to negotiate a lower debt with your creditors. The IRS considers the money that was forgiven (the total amount you didn’t have to pay) as money earned.
 
And because the money is considered income, it’s taxable.
 
On top of the taxable status, debt settlement should be considered after debt consolidation for other reasons. Your creditors or lenders would rather get something than nothing at all, so they opt to settle for a lower debt.
 
However, this path comes with other consequences. As well as damaging your credit score for past-due or defaulted debt, creditors will often choose to put a “settled” status on your credit report.
 
If you are considering debt settlement, you can get creditors to remove the “settled” debt status, removing further damage to your credit score.
 
Both debt settlement and debt consolidation are preferable to bankruptcy. If you'd like to know how to get out of debt with a debt consolidation loan or debt settlement services, try a free consolidation from one of the best debt relief companies.

How to Remove the “Settled Debt” Status from Your Credit Report

Follow these steps for removing “settled debt” from your credit history:
  1. Gather all necessary debt documentation with the individual creditor
  2. Calculate how much debt you can afford to pay each creditor
  3. Call the creditor and let them know how much you can afford to pay
  4. Let them know that you are willing to settle, as long as they agree in writing to write “paid in full” on your credit report
Never give a lender a settled amount without first requesting a written promise to write “paid in full" on your credit report — it’s the only way to avoid the credit consequences of debt settlement.
 
Lenders hate debt settlement. It’s less money for them and makes all debtors think they can settle for less (which is partly true). But you do have some leverage; use that leverage to remove the “settled debt” status.
 
If you have the option, consider a debt consolidation company instead of debt settlement.
 
Sometimes though, debt settlement is the last resort, which is fine. Just remember to attempt to lessen the credit impact if possible.

The Top Debt Relief Companies

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#1 Freedom Debt Relief chevron_right
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#3 Pacific Debt Inc. chevron_right
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