Reduced or Cancelled Debt is Considered Taxable Income

For anyone who has 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. Ideally, you'll have a clean record and you will no longer bear the burden of having to pay a substantial debt. However, if people are not careful with this benefit, they may be setting themselves up for a probable IRS problem. The problem is that they can be taxed on the amount of debt that is reduced as that will be considered as taxable income. So the next time that you get your credit card or other creditors to reduce or cancel your debt, know that you'll automatically be in debt to the IRS. This is among the basic rules regarding cancelled or reduced debt.

Before, getting a loan or having credit card applications approved was rather easy. Because of this, several people become impulsive buyers and irrational spenders. People fail to consider their financial capacity and just went on buying off things.

In reality, however, banks can't put people in jail merely because of massive debt. Often times, when people are delinquent on their debts, the banks and other creditors will simply turnover the collections efforts to a specialized collections firm. Payment to these firms is dependent on how successful they are at collecting money. Now, back on the impact of a reduced 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 in effect, you'll owe the IRS more taxes. 

You can't evade paying taxes on a tax reduction as a copy of your Form 1099-C will be forwarded by your creditors to the IRS. This item shall be reflected on line 21 of tax Form 1040 because this will fall under "other income." The problem gets magnified because you will now be required to pay a huge percentage of the $10,000 to the IRS. This is on top of your regular taxes and state taxes, which you even have difficulty paying off. This example clearly demonstrates why there's a need to understand the effect of a reduced debt on your taxes. While the debt to one party is reduced, a percentage of that debt will be transferred to the IRS. One thing is for sure: you are the still the one who will pay for those debts.

What is worse is that unlike your usual creditors, such as banks or credit card companies, the government actually has the authority to put you in jail for not paying your tax debts. Good thing that courses of action regarding these problems are available. Hypothetically, if your debt on your $200,000 home loan is reduced to only $100,000, naturally, you are to claim to the IRS the other 50% as part of your other income. The thought of paying taxes on that amount alone is already difficult for many taxpayers. Fortunately, the Congress thought that this situation is too harsh and so they moved towards making forms of assistance available to taxpayers. In 2007, a law was passed stipulating that any tax reduction amounting up to $2 million and that is attached to a person's primary residence shall be excluded from the 2007, 2008 and 2009 tax returns. So in our example, you are allowed not to pay taxes on the $100,000 worth of tax reduction. In addition, there are other procedures of getting help on tax payment for reduced debts. If you want to avail of those, make sure you have sought the assistance of a tax professional, otherwise, you might be in another IRS problem once again.

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Originally posted 2008-12-02 22:54:12. Republished by Blog Post Promoter

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