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Cancelled Debt is Part of Your Taxable Income

Having your debt reduced or cancelled is one of the best things that could happen in your life. You record will be cleaned, and you no longer will have the burden of all that de...
Views: 1.556 Created 12/18/2008

Having your debt reduced or cancelled is one of the best things that could happen in your life. You record will be cleaned, and you no longer will have the burden of all that debt hanging over your head. Often, people do not realize that if they're not careful, and don't prepare properly, then they're actually setting themselves up for a probable IRS problem. The problem 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'll be partly indebted to the IRS for this. This is among the basic guidelines concerning cancelled or reduced debt.

During the earlier part of the decade, it was less difficult to get a loan and have a credit card application approved. This led to overspending and impulsivity on purchases. People fail to consider their financial standing and just went on buying off things.

Banks are aware that they can't send people to jail simply for being in massive debt. In many cases, banks and other creditors hire a specialized collections firm so the latter will be the ones to collect from delinquent payers. That firm will get paid on the amount that they have actually collected from the debtors. Now, back on the impact of a reduced or cancelled debt on your taxes. Hypothetically speaking, if you had $20,000 in debt, and you negotiated it down to having to pay only $10,000 with the rest being erased, then the IRS would see that $10,000 reduction as income. This benefit will be included in your taxable income and as a result, you'll owe the IRS more taxes.

You can't get away from paying taxes on a tax reduction as a copy of your Form 1099-C will be forwarded by your creditors to the IRS. This entry shall be reflected on line 21 of tax Form 1040 because this will fall under 'other income.' The problem becomes more evident because you'll 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 scenario is a prime 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 government. What stays constant is the fact that you still have to pay for part of those debts.

The bad news is, the government can send you to jail if you do not pay your tax debts. Good thing that remedies regarding these issues are available. For instance, if the creditor of your home loan decided to reduce your $200,000 loan by $100,000, then you would be required to report that $100,000 to the IRS and have it counted as other income. Having to pay taxes on that amount would literally cause many people to be in serious trouble with the IRS. Fortunately, the Congress felt that this situation is too harsh and so they moved towards providing forms of assistance to taxpayers. In 2007, lawmakers stated that any debt reduction of up to $2 million that is attached to your primary residence can be excluded from your 2007, 2008, and 2009 tax returns. With this law, the taxpayer in the example above will not anymore be obliged to pay taxes on the $10,000 tax reduction. The said law is just among the courses of action related to 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 will not end up inviting IRS trouble into your doorstep.

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