For anyone who's ever been in a serious debt, getting the credit card company or any other creditors to reduce or even cancel your debt is like the best thing that could ever happen to you and your family. You record will be cleaned, and you no longer will have the burden of all that debt hanging on your shoulders. On the contrary, if people are not careful with this benefit, they may be setting themselves up for a probable IRS problem. The bad news is that they can be taxed on the amount of debt that is forgiven as that will be considered as taxable income. So the next time you avail of this benefit, make sure you understand that you will be partly indebted to the IRS for this. That is the general guideline concerning this matter.



Until recently, it was so easy to accumulate credit. For the earlier part of the decade, many people could get loans and be approved for credit cards with relatively little difficulty. In effect, many people just extravagantly spend substantial amounts of money on anything. Without any real restrictions, they eventually spent much more than they could realistically pay off.

Banks understand that they can't send people to jail just for being in massive debt. In mny cases, banks and other creditors hire a private collections firm so the latter will be the ones to collect from delinquent payers. Payment to these firms is dependent on how successful they are at collecting money. Now, back on the effect of a reduced or cancelled debt on your taxes. For example, if you had $20,000 in debt, and you negotiated it down to having to pay only $10,000 with the rest being forgiving, then the IRS would treat that $10,000 reduction as income. This benefit will be added to your taxable income and as a result, you will owe the IRS more taxes.

You will not be able to get away from having to pay because your creditor will send copies of Form 1099-C, reflecting the $10,000 debt reduction, to you and the IRS. This entry will be reflected on line 21 of tax Form 1040 because this will qualify under "other income." The problem on paying taxes worsens because now, you will owe the IRS a certain portion of that $10,000. This is aside from being required to pay for your regular and state taxes. This example clearly illustrates why there is a need to understand the effect of a reduced debt on your taxes. Your debts to your creditors maybe erased, but these are transferred to the IRS. One thing is for sure: you're the still the one who will pay for those debts.

Unlike other creditors, the government actually has the power to put you in jail for not paying your taxes. Fortunately, people are provided with remedies for this kind of situation. For instance, if your home loan is reduced from $200,000 to $100,000, the other $100,000 must be reported to the IRS and shall be counted as part of your other income. Having to pay taxes on such a large amount of money is more likely to put you in trouble with the IRS. Fortunately, by 2007, Congress has passed a law stipulating that any tax reduction of up to $2 million and that is attached to your primary residence, will be excluded from our 2007, 2008 and 2009 tax returns. In our example above, you will be exempted from paying taxes on the tax reduction because of this new policy. On another note, there are still a lot of measures that will help you deal with tax payments on reduced debt. It is best that you consult a tax professional first before availing any of these procedures.