irs tax on cancelled debtWhen you run into tough times, and have debt canceled or forgiven, you are often so relieved for the problem to be over that you don’t think about the tax consequences. In fact, you might be forgiven for thinking that there aren’t any tax consequences. After all, you don’t have any money. That’s why your debt was canceled.

Unfortunately, as many debtors find out come tax time, the IRS keeps track of canceled debt, and considers it income in many cases. Indeed, if a creditor agrees to cancel at least $600 of your outstanding debt, it is seen as income. After all, the IRS points out, you received the money – and you aren’t paying it back.

When you get a loan, since you mean to pay it back, it’s not considered income. However, once that debt is forgiven, it’s as though you have received the money for free. And the IRS views that as income. If you borrowed $5,000, and only paid back half before defaulting and having the debt canceled, that appears as income as $2,500 to the IRS. You have to report it as income, and pay taxes on it.

How much you pay depends on your circumstances, of course. If your income is low enough, even with the debt cancellation, you may not owe taxes. The important thing is to remember that you need to add in forgiven debt as part of your income calculation when filling out your tax return form.

1099-C Form

Your creditor reports the canceled debt on Form 1099-C. This form describes the amount of the debt that was forgiven. This is the amount that you are required to fill in on your 1040 form on Line 21 as “other income.”

Be on the lookout for this form, since it will likely come from a creditor. Don’t think that you can just throw out the communication because your business with the creditor is done. You need to file this form along with your tax return. The creditor has reported the information to the IRS, so you might be audited if you don’t include the form.

Mortgage Debt

Normally, mortgage debt falls in this category as well. However, the provisions of the Mortgage Debt Relief Act of 2007 are extended to include tax year 2012. So, if your debt was reduced through mortgage restructuring or because of foreclosure, you might be excluded from paying the tax. Up to $2 million in mortgage debt can be forgiven without it being considered income by the IRS. After 2012 (unless something changes), mortgage debt will go back to being considered income. You can read more about the tax implications of mortgage debt here.

Before you settle your debt, and attempt to receive loan forgiveness, double check the consequences. You want to make sure it won’t really cost you more than it’s worth. If you have questions about whether or not you owe money, and whether or not you qualify for an exclusion, contact a knowledgeable tax professional, or the IRS. You want to make sure that you are properly reporting all of your income to reduce the chances of an audit.