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Avoiding taxes on canceled debt

By Kay Bell ·
Thursday, March 22, 2012
Posted: 3 pm ET

One of the worst tax surprises is that canceled debt generally is taxable.

That means that if you owe $10,000 on a credit card and negotiate the balance down to $3,000, then the $7,000 that the company forgives is considered $7,000 in taxable income to you.

Of course, most people won't let a potential tax bill prevent them from working out a debt-payment deal. After all, they have their credit rating to consider, not to mention their cash flow situation that will benefit greatly from a lower debt load and smaller monthly payment obligations.

But the potential tax bill is something you need to be aware of.

If the canceled debt does subsequently present tax troubles, contact the Internal Revenue Service, and let it know what happened.

A lot of folks are in the same fiscally leaky boat right now, and the IRS has instituted protocols that allow it to work with people who are struggling financially. While the tax agency does want its eventual due, IRS Commissioner Douglas Shulman has told his staff to find ways to do their jobs without adding to taxpayers already large financial burdens.

OK, here's where things get interesting, and by now you know that "interesting" in tax-speak means convoluted. You did note the word "generally" in the first paragraph, right? That means that when it comes to canceled debt, there are tax exceptions.

You might not need to worry about the IRS if your situation is one of those few exceptions in which canceled debt is tax-free.

A specific exclusion has been in effect since 2007 for homeowners facing potential loss of their homes. The Mortgage Forgiveness Debt Relief Act has allowed taxpayers to exclude debt forgiven on their principal residences when the mortgage is restructured or the property goes into foreclosure. That tax-free debt option is still in effect through the 2012 tax year.

You also won't have to pay tax on canceled debt if you can show the IRS that you're bankrupt or insolvent.

Debts discharged through a Chapter 11 bankruptcy are not considered taxable income.

Insolvency isn't as complicated as the whole bankruptcy route. Here you just need to show the IRS that immediately before the debt was canceled, your total debts were more than the fair market value of your total assets. The IRS has a worksheet to help you determine if you meet these requirements.

Neither bankruptcy nor insolvency nor impending foreclose is an ideal situation, for tax or general financial purposes. But sometimes they are unavoidable and they at least can help out with your IRS bill.

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1 Comment
Jones Smith
March 24, 2012 at 7:18 am

There ought to be an exception rule for IRS 1099C account as nontaxabable income, if for example: college education, first-time homebuyer, or healthcare costs. This way lower income taxpayers will become actually paying taxes again to both federal and state(s) tax returns when his/her earned income increases to 20%-30% and 3%-6% tax brackets, respectively.