Reduced or Cancelled Debt is Part of Your 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 seems 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 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, be aware that you'll automatically be in debt to the Internal Revenue Service. That's the general guideline pertaining to this matter.

Until recently, it was rather 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. Many people spent impulsively and accumulate substantial sums of debt. Too much have they spent that they lose track of their financial capability to realistically pay off their debts.

In reality, however, banks cannot 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 undertaking to a private collections firm. Payment to these firms is dependent on how successful they are at collecting money. Now, back on the impact of a reduced or cancelled debt on your taxes. For instance, if you have successfully convinced your creditor to reduce your $20,000 debt to only $10,000, that $10,000 will be treated by the IRS 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 item shall be reflected on line 21 of tax Form 1040 because this will fall under "other income." The problem on paying taxes worsens because now, you will owe the IRS a certain percentage of that $10,000. This is aside from your regular taxes and state taxes, which you even have trouble paying off. This case is a good example of why first and foremost, there is a need to understand the implications of a reduced debt. While the debt to one party is reduced, a portion of that debt will be transferred to the IRS. One thing remains: you're the still the one who will pay for those debts.

The bad news is, the government can send you to jail if you don't pay your tax debts. Good thing that there are measures for this federal consequence. 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. Having to pay taxes on such large amount of money would literally cause many people to be in serious trouble with the IRS. Fortunately, Congress believed that in a case like this, taxpayers were being put into a hole they would never be able to climb out of and that it would be better to give them aid in a time of such need. In 2007, a law was passed stating that any tax reduction amounting up to $2 million and that is attached to a person's primary residence will 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. The said law is just among the courses of action concerning tax reductions, there are still others available. Just be certain that have a tax professional by your side when you decide to avail of those remedies so you won't end up inviting IRS problems into your doorstep.