"Forgive but collect" is the IRS motto when it comes to canceled debt.
Getting your credit card bill cut from $8,000 to $4,000 certainly helped your personal bottom line. But it also could be a boon to the U.S. Treasury. Why? The tax law generally considers the amount you get any creditor to write off as earned, and therefore taxable, income to you. Expect the accommodating debtholder to send you (and the IRS) a Form 1099-C or similar statement detailing your discharge of indebtedness as miscellaneous income.
Not every debt settlement, however, has to pad Uncle Sam's pocket. Under the Mortgage Debt Relief Act that became law in 2007, some homeowners who are granted forgiveness of mortgage debt won't have to pay taxes on that amount.
There are some restrictions. The forgiven debt amount is limited to up to $2 million, or $1 million for a married person filing a separate tax return. The tax relief applies only to mortgage debt discharged by a lender between 2007 and 2014. And the forgiven loan must have been taken out to buy or build a primary residence, not a 2nd home or vacation home.
This tax break also is temporary. It was extended through 2016 as part of the Protecting Americans from Tax Hikes, or PATH, Act of 2015. However, if Congress doesn't extend mortgage debt relief beyond this year, canceled home loan debt will return to the taxable income category.