Canceled debt can become a tax liability

Bills are piling up to the point where you dread opening your mailbox. If only your creditors would forgive your debt. Sometimes, they will -- but even then your money troubles might not disappear. Canceled debt in many cases is considered taxable income. And if a creditor forgives thousands of dollars of debt, you can find yourself whacked by a big tax bill. And that is not the only consequence. Forgiven debt can raise your income to the point where you're ineligible for certain credits and tax deductions, or part of your Social Security benefits is taxed, said Bob Scharin, a senior tax analyst with Thomson Tax & Accounting. Of course, having a creditor absolve you of debt can be a financial lifesaver. Still, a tax bill isn't what many expect when debt is being erased. "People definitely are initially shocked," said Robin McKinney, executive director of the Maryland Cash Campaign, which helps lower-income taxpayers file returns. McKinney said she sees many such cases of shock now with car loans. The cars are repossessed and the loan balances wiped out, yet consumers receive a form saying they owe taxes on thousands of dollars of forgiven debt. "Some people have even said, 'If I had known this was a consequence, maybe I would have tried harder to refinance the loan,' " she said. Credit-card bills are one of the most frequent types of forgiven debt -- and it is taxable.Scharin notes an instance in which a consumer owed $21,270 on his credit card in 2004. The issuer, MBNA America Bank, agreed to accept about $4,600 to settle the debt. But the consumer balked at paying taxes on the $16,670. He argued that the settlement was a retroactive lowering of his interest rate and that he had repaid the principal. A tax court recently ruled against him.Home-mortgage debt is another area where many are trying to negotiate relief. Given the rise of foreclosures, Congress granted a temporary tax break for those whose housing debt is wiped out. Under the new law, you won't have to pay taxes on up to $2 million of forgiven debt on a primary residence. Any debt wiped out on a second home is still subject to tax. If the bank forgives the home-equity loan you used to make substantial improvements to the house, that won't be taxed, either, Scharin said. But if that home-equity loan was taken out for other reasons -- say, to buy a car -- then the forgiven debt will be taxed. Again, this tax break is temporary. It applies to mortgage debt forgiven last year and through 2009. Students, too, can catch a break. Many student-loan forgiveness programs are available if borrowers work in particular fields, such as nursing or teaching, after graduation. This debt relief is not taxed, Scharin said. Steve Hannan, executive director of the Maryland Consumers Rights Coalition, said negotiating for debt relief "is a good move," but you must realize the tax consequences. He advises consumers to obtain any settlement in writing and find out if the creditor will notify credit-reporting agencies that the debt is forgiven. "It doesn't do any good if the debt has been forgiven but nobody knows about it," he said. Keep all documentation to prove the debt was forgiven, in case a debt collector in the future tries to collect it again, he said. While credit-card debt generally is taxed, it won't be taxed along with any other debt that is canceled in cases of bankruptcy or insolvency. As for documents, if you have $600 or more of canceled debt, you will receive a Cancellation of Debt form, or 1099-C, for tax purposes. (Even if the amount is less than $600, you are expected to report it as "other income" on your tax Form 1040.) The IRS wants you to pay taxes on a pay-as-you-go-basis, McKinney said. If it looks as if you will owe a chunk of taxes on forgiven debt, you should pay estimated taxes on the amount or risk being hit with a penalty later, she said. If you don't have the money to pay the tax bill, you'll have to set up a payment plan with the IRS, she said.