I don’t know why advisers advise that taking a debt settlement will hurt your score significantly. I see that advice a lot, and I don’t understand it. A vast majority of the time, debt settlements occur with junk debt buyers/external collection agencies. By the time a debtor is speaking to those people, two things have happened: There is a 90 day late reported on the original creditor’s tradeline, and second, a collection item has appeared on the report. These two things have already torpedoed your score anyway. How, exactly, does the settlement make it worse? (Said a bit differently… once the collection item hits your report, paying it off doesn’t make it go away, nor does the payment improve your FICO score. So why would a settlement decrease your score further?)
Now, if the account is still with the original creditor, then two things are likely true: 1) The account is less than 90 days past due, and 2) There is no collection-related item on the credit report. In that case, yeah, I can see that a settlement program could be harmful. But that’s not really how this was presented in the article — the presentation was “you better think twice about debt settlement” while it should have been, “if you are already in collections, take the gift for what it is, if not, then think twice.”
And finally, the settled difference only results in a true tax basis if you are solvent. If your liabilities (debts) exceed your assets, you won’t pay any tax on this settlement.