You’re Required to Pay Taxes on Cancelled Debt

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Getting your debt reduced or cancelled is a major cause for celebration as your records will be cleaned and you will no longer suffer from paying for a substantial amount of money. Just note that the government treats a reduced or cancelled debt as taxable income, and so you’ll be required to pay taxes on this. In addition, as this is one the basic guidelines concerning reduced or cancelled debts, be certain that you do not neglect this fact when it is time to file for your tax returns.

During the earlier part of the decade, it was relatively easy to get a loan and have a credit card application approved. This led to overspending and impulsive on purchases. Unfortunately, people lose sight of the fact that they need to pay for all these debts.

Banks are aware that they do not have the legal authority to send people to jail just because of a massive debt. Hence, in certain situations, they hire private agencies to collect from delinquent debtors. These firms will be compensated by the banks on a percentage basis, depending upon how much they’ve collected from the debtors. Now, back to reduced or cancelled debts. Consider an instance when your original $20,000 debt was reduced to $10,000 and the remaining was forgiven. In this case, you will be obligated to pay taxes on $10,000 as that will form part of your income.

You cannot get away from paying taxes on a tax reduction as a copy of your Form 1099-C will be forwarded by your creditors to the IRS. The IRS considers this as “other income”, which gets reflected on line 21 of tax Form 1040. The problem on paying taxes worsens because now, you will owe the IRS a certain percentage of that $10,000. This is aside from your regular taxes and state taxes, which you even have difficulty paying off. This scenario is a good example of why first and foremost, there is a need to understand the implications of a reduced debt. Your debts to your creditors maybe eliminated, but these are transferred to the IRS. One thing remains: you’re the still the one who will pay for those debts.

Unlike other creditors, the IRS actually has the power to put you in jail for not paying your taxes. Fortunately, people are given remedies for this kind of situation. For instance, if the creditor of your home forgave $100,000 from your total debt of $200,000, naturally, $100,000 will be reported to the IRS as “other income.” Having to pay taxes on such a substantial amount of money is more likely to put you in trouble with the IRS. Fortunately in 2007, Congress has passed a policy specifying that tax reductions amounting up to $2 million and attached to your primary residence are to be excluded from your 2007, 2008 and 2009 tax returns. In our scenario above, you’ll be exempted from paying taxes on the tax reduction because of this new law. On another light, the IRS also provides several remedies for tax payments on reduced debt. Prior to availing any of these, make sure that you have asked assistance from a tax professional.

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