Reduced or Cancelled Debt is Considered Taxable Income

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

Banks know that they don't have the legal authority to send people to jail just because of a massive debt. Thus, in certain situations, they hire private firms to collect from delinquent debtors. These firms will be compensated by the banks on a percentage basis, depending upon how much they have collected from the borrowers. Let us now go back to the topic on reduced debts. Consider an instance when your original $20,000 debt was reduced to $10,000 and the remaining was forgiven. In this scenario, you'll be required to pay taxes on $10,000 as that will form part of your income.

The IRS will certainly know of a reduced tax because your creditors will give them a copy of your Form 1099-C. This will be considered as part of your other income, which is written on line 21 of Form 1040. In the above scenario, instead of paying to your creditors, you'll now be paying a certain percentage of $10,000 to the IRS. In effect, getting a tax reduction will lead to more taxes as this new income will be added on top of your regular and state taxes.. This example clearly shows why there is a need to understand the effects of a tax reduction first prior to subjecting yourself into one.

The bad news is, the government can send you to jail if you do not pay your tax debts. Good thing that there are remedies for this federal consequence. For example, if the lender 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. The thought of paying taxes on that amount alone is already difficult for many people. Fortunately, Congress felt 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 stipulating 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. With this law, the taxpayer in the example above will not anymore be obliged to pay taxes on the $10,000 tax reduction. Also, there are other procedures of getting help on tax payment for reduced debts. If you want to avail of those, make sure you have asked for the help of a tax professional, otherwise, you might be in another IRS problem once again.