Debt settlement has become a popular approach to resolving problem debts without having to document bankruptcy. With this approach, creditors agree to accept a portion of what you owe (usually around 50% or less) to settle the account, and the remaining balance is forgiven. This technique will certainly continue to grow in popularity now that the new bankruptcy law makes it tougher to fully discharge debts in a Chapter 7 bankruptcy.

As with anything, there is no free lunch, and creditors are required to report canceled debts to the IRS on Form 1099 (when the canceled balance is $600 or greater). Therefore, the possibility exists that you can owe taxes on the forgiven portion of the debt. For this reason, many financial writers and debt counselors are strongly critical of debt settlement, to the point where they actually recommend against it just because you might finish up owing taxes. But the tax consequences of settling your debts are greatly over-emphasized, and this is a really just a minor issue at best.

First, even if you finish up owing taxes on the canceled balances, thats because you saved a bunch of money off your original debts. The total of what you paid the creditor, plus the taxes, will still be much less than what you owed to start with. There is still a net savings. So its hard to understand why this is viewed as a problem in the first place!

Second, the efficient majority of all the people who settle their debts are not required to pay taxes on the forgiven part of the balance. Thats because of the "insolvency" rule, described in IRS Publication 908, "Bankruptcy Tax Guide." Do not let the title fool you. You do not positive need to have filed a formal declaration of bankruptcy to take advantage of the insolvency rule.

Basically, "insolvent" means that you have a negative net assessment of worth -- that is, you "owe" more than you "own." As a consequence, most debtors do not have a taxation liability on the canceled debts, simply because most debtors are insolvent! It usually comes down to home equity. If you have enough equity in a home (or other property) to outweigh the total of your liabilities (debts), then you have a positive net assessment of worth , and will likely have to pay taxes on the forgiven debt amounts. However, the majority of all the people in serious debt trouble have a negative net value, and are therefore insolvent. The way it works is that you might offset the canceled debt up to the amount by which you were insolvent at the time you did the settlement.

Come taxation time, be sure to get professional taxation advice distinctive to your situation. Also, be sure to read the section in IRS Publication 908 on "reduction of taxation attributes," which requires many people using the insolvency rule to reduce their basis in such things as rental property, loss carryovers, etc. Most of that probably wont apply to you, but again, get defined advice before winging it.

So, the communication is, relax about paying taxes on canceled debt balances. That should be the least of your concerns if youre upside down financially. Dont let the misguided criticisms of financial writers (who havent done their homework) discourage you from looking into one of the most popular and flexible options for achieving debt-freedom.