Do you have to pay taxes on debt settlement?

If your debt becomes unmanageable, you may benefit from working with a debt relief or debt settlement company.

These firms reach out to lenders and collections agencies on your behalf and try to negotiate down the amount owed. The theory is that a creditor would rather have some of their money back than none at all.

In exchange, the company charges a fee that can be as much as 25% of the agreed-upon balance. There may also be additional costs for keeping your payments in an escrow account while the company negotiates with creditors.

In a best-case scenario, a debt settlement company can wipe away a large chunk of a client's debt. In the eyes of the IRS, however, having a debt forgiven is akin to earning income.

"You will be taxed on any forgiven debt over $600," debt relief attorney Leslie H. Tayne of Tayne Law Group told CNBC Select. "There are exceptions, but even if you do pay taxes on it, you'll generally still be better off than if you had to pay the full sum."

Debt relief companies help borrowers with large balances, typically at least $7,500 or $10,000, negotiate a settlement for less than the full amount owed.

Representatives make an offer to your creditors on your behalf. Typically, they will tell you to stop making payments to your lender and instead funnel money into a special escrow account. If the creditor agrees to the deal, the money in the account is transferred and the balance is wiped clean. In some cases, borrowers can see as much as 50% of their balances erased.

For-profit debt settlement companies can charge anywhere from 14% to 25% of the total enrolled debt for this service. Depending on how much of your debt it can get forgiven, however, you could still come out well ahead.

Because the creditors are under no obligation to agree to a deal, there is a fair amount of risk involved. Your lender could keep adding on more fees and interest during negotiations or even pursue legal action for nonpayment. Even if the process is successful, your credit will take a significant hit.

Lastly, if you're able to get a settlement, you'll probably owe taxes on the difference you saved.

Any forgiven debt over $600 is considered taxable income. 

"The creditor is required to file a 1099-C form with the IRS, which will detail the amount of your settled debt," said Tayne.

The forgiven amount is the amount that's taxable income.

There are some exceptions and exclusions, however.

1. Money given as a gift, bequest or inheritance
2. Certain discharged student loans, including those that are forgiven based on length of employment in certain field or organization.
3. Deductible debt, like mortgage interest, and price reductions by the seller of property to the buyer

Some types of debt may be lowered or reduced, but they must be filed as an exclusion using Form 982. They are:

• Discharge of debt through bankruptcy
• Discharge of debt of an insolvent taxpayer
• Discharge of qualified farm indebtedness
• Discharge of qualified real property business indebtedness
• Discharge of qualified principal residence indebtedness

The details of your debt forgiveness plan will not show up on your credit report, says Tayne. The delinquent amount will simply show up as "settled" rather than "paid in full."

But since debt settlement companies encourage clients to stop making payments to creditors, your credit score will undoubtedly take a hit. You could see a decline of more than 100 points, according to Debt.org.

Payment history makes up 35% of your score and a black mark can remain on your report for up to seven years. But it may be worth it in the long run compared to the damage wreaked by years of delinquent payments.

"Your credit may be temporarily damaged, but it will come back up quickly," Tayne says. "Generally, it does work out in the debtor's favor to settle the debt, especially if simply paying it off isn't a real option."

At CNBC Select, we work with experts who have specialized knowledge and authority based on relevant training and/or experience. For this story, we interviewed Leslie H. Tayne, a debt relief attorney and founder of Tayne Law Group.

At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every debt relief service review is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of debt relief products. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics.

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