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IRS Doesn't Forget Your Debt Forgiveness Income

Your creditors may forgive debt, but it is unlikely that the IRS will forget. Many people who have received debt relief may not know that their debt settlement counts as taxable income. As a result, they are caught unprepared when the tax man comes. Those who are looking to absolve their credit card debt through nonbankruptcy proceedings should know the ins and outs of the tax code before agreeing to a settlement.

The IRS considers any forgiven debt over $600 to be taxable income. When you borrow money, you are not taxed on it because you are expected to pay it back. If you are unable to do so, though, you essentially got that money for free. You were able to buy clothes, gas, food and other items with your card. As a result, the IRS views that money as taxable income that will be subject to both federal and state withholdings.

Some exceptions to this rule do exist. For example, if you are considered "insolvent" -- that is, if your overall debts exceed all of your assets, you can be off the hook for the required income tax. Credit card forgiveness connected to bankruptcy is also exempted.

Additionally, tax experts say that mortgage debt that was cleared between 2007 and 2013 is not taxable, thanks to special provisions stated in new foreclosure regulations. This is only true of mortgage debt that was used to buy, build or improve an existing house, however; if you used a second mortgage to finance your kid's college education, you will not be able to avoid tax liability.

Married couples and divorced couples are permitted to exempt different amounts of debt forgiveness related to their mortgages. Be sure to check with qualified financial planners and bankruptcy attorneys to help you determine the status of your credit card debt forgiveness. Experts can help you evaluate your tax and other financial options after a debt forgiveness has occurred.

Source: Marketwatch, "Creditors may forgive, but IRS doesn't forget," Jennifer Waters, March 11, 2013

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