Forgiven debt could increase your tax bill
By Jenny C. McCune • Bankrate.com

All may be forgiven when a debtor reduces the amount you owe, but that doesn't mean you've gotten a free ride. Your windfall may be taxable.

"It's a great way for the IRS to make money," says Steve Rhode, co-founder and president of MyVesta, a debt-counseling organization.

Here's how it works. You negotiate with your credit card company to get your bill reduced from $10,000 to $5,000. You only have to pay Visa $5,000, but the Internal Revenue Service is likely to tax you on the $5,000 you didn't have to pay back. That amount is known as discharge of indebtedness, or DOI, income.

That's right. A debt forgiven won't be forgotten by the IRS. The agency considers it earned and taxable income. In fact, your debtor probably will send you a 1099 form detailing your miscellaneous income. Don't think you're free from the IRS if you don't get the form. The debtor may have reported the "income" to Uncle Sam even though he didn't fill out your paperwork.

"It's a tax trap," says Barbara Weltman, tax attorney and author of J.K. Lasser's Tax Savings in Your Pocket. "Any debt that is forgiven is counted as income, and you owe taxes on the amount that's forgiven."

To cut your debt or not

So does this mean you shouldn't try to reduce the amount you owe? Not necessarily. But you should consider how the debt discharge could affect what you owe the federal government come tax time. "What you have to do is recognize you'll have to pay taxes and factor that into your negotiations and your financial planning," Weltman says. For example, will the DOI income, also known as phantom income, push you into a higher tax bracket? Or will you be able to afford to pay the extra amount in taxes come April?

Not every debt settlement, however, has to lead to a higher tax bill. You don't have to report debt forgiven as income if:

You contest the liability. If your debt settlement is achieved because you protest an owed amount, the forgiven debt is excluded from the DOI rule. Some people encounter this situation when they dispute credit card charges. For example, MasterCard contends you owe $1,000 but you didn't buy those Ferragamo shoes. The debate rages on for weeks. Finally, to put an end to the quibbling, you offer to pay $200 and MasterCard says OK. That $800 difference is a settlement of contested liability, and you're not liable for taxes on it.

You are in bankruptcy proceedings. When you're paying a portion of what you owe because you've declared bankruptcy, the IRS does not consider the difference between those amounts discharge of indebtedness income.

You are insolvent. This means your liabilities exceed your assets. Forgiven debt in these cases is not taxable.
Tax attorney Weltman also points to the gray area that's arisen because of IRS amnesty programs. If the IRS forgives part of your delinquent tax payments, does that count as income? "We'll have to wait and see what happens in those cases," Weltman says.

The bottom line: Consider all the financial implications, including taxes, of debt forgiveness. Negotiating to reduce what you owe could be a wise move, but go into the arrangement with your eyes (and wallet) open. In many cases, the IRS is going to want its piece of the discharged debt.

Jenny C. McCune is a contributing editor based in Montana.