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You are Required to Pay Taxes on Cancelled Debt
By Darrin Mish
Having your debt reduced or cancelled is one of the best things that could happen in your life. Ideally, you'll have a clear record and you will no longer bear the burden of having to pay a large debt. Often, people do not realize that if they are not careful, and don't prepare properly, then they're actually setting themselves up for a potential IRS trouble. The fact is, the IRS considers the reduced or cancelled debt as taxable income, hence, you'll be required to pay taxes on this. So the next time you avail of this benefit, make sure you understand that you'll be partly indebted to the IRS for this. That is the basic guideline pertaining to this matter. Credit was quite easy to accumulate until the recent years. For the earlier part of the decade, several people could get loans and be approved for credit cards with relatively no difficulty. Many people spent impulsively and accumulate substantial sums of debt. Without any real restrictions, they eventually spent much more than they could realistically pay off. Banks know that sending people to jail because of massive debt is not legal. Hence, in certain situations, they hire private agencies to collect from delinquent debtors. These firms will be paid by the banks on a percentage basis, depending upon how much they have collected from the borrowers. 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 scenario, you'll be obligated to pay taxes on $10,000 as that will form part of your income. You cannot evade paying taxes on a tax reduction as a copy of your Form 1099-C will be sent by your creditors to the IRS. This entry shall be reflected on line 21 of tax Form 1040 because this will qualify under 'other income.' The problem on paying taxes is magnified because now, you'll owe the IRS a certain percentage of that $10,000. This is on top of your regular taxes and state taxes, which you even have trouble paying off. This scenario is a good example of why first and foremost, there's a need to understand the implications of a reduced debt. Your debts to your creditors maybe erased, but these are transferred to the government. One thing is for sure: you're the still the one who will pay for those debts. Unlike regular creditors, the government can send you to jail if you consistently do not pay your taxes. Fortunately, people are given remedies for this kind of problem. For example, 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 part of your 'other income.' With such an amount of money to pay taxes on, it is rather likely that you'll be bumping into an IRS trouble. Fortunately in 2007, Congress has passed a policy specifying that tax reductions amounting to a maximum of $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 will be exempted from paying taxes on the tax reduction because of this new law. On another light, the government also provides several remedies for tax payments on reduced debt. It is best that you refer to a tax professional first before availing any of these procedures.
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