You're Required to Pay Taxes on Cancelled Debt

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. Ideally, you will have a clear record and you'll no longer suffer the burden of having to pay a large debt. Often, people don't realize that if they're not careful, and do not prepare properly, then they are actually setting themselves up for a potential IRS trouble. The fact is, the IRS considers the reduced or cancelled debt as taxable income, thus, you'll be required to pay taxes on this. 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 one of the basic guidelines regarding cancelled or reduced debt.

During the earlier part of the decade, it was relatively easy to get a loan and have a credit card application approved. As a result, several people become impulsive buyers and irrational spenders. Unfortunately, people forget the fact that they need to pay for all these debts.

Banks are aware that they don't have the legal right to send people to jail just because of a massive debt. This is why in certain situations, they hire specialized firms to take on the task of collecting money from delinquent debtors. These firms will be compensated by the banks on a percentage basis, depending upon how much they've collected from the borrowers. Now, back to reduced or cancelled debts. Take for instance the case of someone whose debt of $20,000 was reduced to $10,000 as the other half was forgiven. In this case, you'll be required to pay taxes on $10,000 as that will form part of your income. 

You will not be able to escape having to pay because your creditor will send copies of Form 1099-C, reflecting the $10,000 debt reduction, to you and the IRS. The IRS considers this as "other income", which gets reflected on line 21 of tax Form 1040. The problem on paying taxes worsens because now, you will owe the IRS a certain percentage of that $10,000. This is aside from having to pay for your regular and state taxes. This example clearly demonstrates why there's a need to understand the effect of a reduced debt on your taxes. Your debts to your creditors maybe eliminated, but these are transferred to the government. One thing remains: 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 IRS actually has the power to put you in jail for not paying your tax debts. Good thing that remedies regarding these problems are available. In a hypothetical sense, 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 burdensome for many people. Fortunately, the Congress felt that this case is too harsh and so they moved towards providing forms of assistance to taxpayers. In 2007, lawmakers stipulated that any debt reduction of up to $2 million that is attached to your primary home can be excluded from your 2007, 2008, and 2009 tax returns. With this law, the taxpayer in the scenario above will not anymore be required to pay taxes on the $10,000 tax reduction. The said law is just on of the courses of action related to tax reductions, there are still others available. If you want to avail of those, make sure you have sought the help of a tax professional, otherwise, you might be in another IRS problem once again.

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