Debt Settlement Legal Hurdles

Understanding the legal implications of debt settlement is essential to moving forward from a bad debt situation. Even if you intend to try a "do it yourself settlement," meaning you will not be using a settlement agency or a settlement attorney, it is still best to have legal counsel for a final review of the settlement you arrange. Basically, debts are a legal obligation formed by a binding contract. When you are closing this contract, you need to make sure the steps are legally performed. Otherwise, the settlement may be void in the future.

Contract Law

Contract law is a required area of study for all students attending law school. When a lawyer sits for the state bar, contracts are a section she is supposed to be intimately familiar with. Each state has specific rules governing how contracts are formed, changed, nullified and corrected. A person who is not familiar with these laws would create a contract that does not have legal validity in the state where it is created. In business terms, this is often referred to as errors and omissions knowledge. A casual contract writer could easily leave out an essential clause or piece of information that would later render the contract invalid or incomplete. When you settle a debt, you will be modifying a contract. Leaving out important information means the changes you make could be invalid, and you may be on the hook for the entire loan even if you think you have settled the debt.

Debts in Bankruptcy

The possibility you have not settled a debt legally comes into play in a much more significant way if you later declare bankruptcy or enter a debt court. Your entire debt portfolio will have to be addressed in a court of law. Any contract that does not stand up to the court will be dismissed. If your lender decides to call in the loan again, even though you believed it was settled, a judge will have to review the debt and any modifications to the contract. Your modifications may be determined invalid, meaning you would be required to state the debt as part of the bankruptcy proceeding.

Tax Obligations with Forgiven Debt

If you are able to settle a debt effectively with an accurate contract, you will still want to consult with an accountant regarding what this will mean for your tax obligation. Many people fail to realize loans can be considered income if they are not repaid. For example, if you take a home equity loan for $50,000 to improve your home, this income is not initially taxed because you will have to repay the debt later. If you settle a portion of the debt, you are not repaying the debt in full, so you have actually made an income on the loan. This is a threat with equity debt specifically because it was used to purchase an asset. If you want to ensure you do not owe taxes on the forgiven debt, you should speak with an accountant regarding dealing with this concern.

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