Tax Implications of Cancelled Debt

As many Americans continue to struggle financially through this tough economy, a flurry of debt counselors and debt reduction options have flourished and become big business. While many of these companies provide plans to settle your debt for less than you owe or negiotiate short sales on mortgages for overvalued homes, these programs typically fail to mention one important factor - your tax burden from the debt you are not paying. 

Within the tax code, when a debt is forgiven, a creditor must file this debt with a 1099-C form. This means, for all taxable purposes, one's gain in not paying the debt is translated into taxable income. In short, the debt you aren't paying is now counted as income earned and you will still have to pay something for this cancelled debt in the form of income tax.

For instance, if your annual income is $45,000 and you have $10,000 in credit card debt cancelled or "forgiven" through the use of a debt reduction agency, your new taxable income through the IRS is $55,000, resulting in about $2,600 in additional taxes owed for a single filer. The 1099-C form will be sent to you from the creditor as they will take the deduction for their tax purposes.

Keep in mind that a failure to pay taxes may have significantly more severe consequences than a failure to pay the initial debt, and the interest rates from the IRS can also be significant.

There are exclusions to cancelled debt being considered taxable income, most notably if "the discharge occurs in a Title 11 case" [Internal Revenue Code Title 26, Section 108] which would be in the instance of bankruptcy (Chapter 7 or Chapter 13 for example). While an individual would still receive a 1099-C, they can also file a Form 982 so that the debt is not considered taxable income.

It is best to consider speaking with a bankruptcy attorney first to measure your personal situation in regards to the implications of cancelled debt and tax liability. While a cancellation of debt may seem a great short term option, the lingering effects of taxes may prove bankruptcy as a better financial move.