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I had a portion of my debt canceled after working out a debt settlement. A friend of mine said there’s a catch to this arrangement because I’ll have to pay taxes. Is this true? Will I have to pay taxes on the forgiven portion of my debt?
It depends on the type of debt that was forgiven. According to the IRS, forgiven debt is taxable because it’s counted as income. And the forgiven amount must be reported as income. You should expect to receive a form from your lender known as Form 1099-C, cancellation of debt. Credit and debt collectors who forgive a minimum of $600 from a debt such as credit card, auto, or mortgage are required to file with the IRS. You’re entitled to a copy of the paperwork.
You didn’t mention what type of debt you had canceled, but there are some cases where you might be eligible for an exclusion from paying the taxes (Note: you may have different tax obligations on the federal and state level). One example is mortgage debt. Under the Mortgage Forgiveness Debt Relief Act, if your mortgage is partially forgiven from 2007 through the 2012 tax years, you might be eligible to apply for tax relief and exclude the forgiven debt from your income. Debts discharged during bankruptcy are also eligible for exclusion.
Your best bet is to check with your tax professional who can advise you of your federal and state tax obligations. (Read “Choosing the Right Tax Professional” Shopsmart, April 2008). You can search the National Association of Tax Professionals online database by zip code to find a tax preparer in your area.