The IRS may count a debt written off or settled by your creditor as income to you.

An IRS law could cost you money if you settle a debt with a creditor for less than the full amount. Likewise, this rule could shrink your wallet if a creditor writes off a debt you owe -- that is, ceases collection efforts, declares the debt uncollectible, and reports it as a tax loss to the IRS. (26 U.S.C. § 108.) This is because you must report forgiven debt as income, with certain important exceptions. Debts subject to this law include money owed after foreclosure or property repossession or a credit card bill you don't pay.

IRS Reporting

Any financial institution that forgives or writes off $600 or more of a debt's principal (the amount not attributable to interest or fees) must send you and the IRS a Form 1099-C at the end of the tax year. These forms are for the report of income, which means that when you file your tax return for the tax year in which your debt was settled or written off, the IRS will make sure that you report the amount on the Form 1099-C as income.

Even if you don't get a Form 1099-C from a creditor, the creditor may very well have submitted one to the IRS. If you haven't listed the income on your tax return and the creditor has provided the information to the IRS, you could get a tax bill or, worse, an audit notice. This could end up costing you more (in IRS interest and penalties) in the long run.

Exceptions to Reporting Income

There are several exceptions stated in the Internal Revenue Code. For example, if the financial institution issues a Form 1099-C, you do not have to report the income on your tax return if:

• the cancellation or write off of the debt is intended as a gift (this would be unusual)
• you discharge the debt in bankruptcy, or
• you were insolvent before the creditor agreed to settle or write off the debt.

Insolvency means that your debts exceed the value of your assets. To figure out whether or not you were insolvent, you will have to total up your assets and your debts, including the debt that was settled or written off.

Example 1: Your assets are worth $35,000 and your debts total $45,000. You are insolvent to the tune of $10,000. You settle a debt with a creditor who agrees to forgive $8,500. You do not have to report any of that money as income on your tax return.

Example 2: Your assets are worth $35,000 and your debts still total $45,000, but the creditor writes off a $14,000 debt. You don't have to report $10,000 of the income, but you will have to report $4,000 on your tax return.

If you conclude that your debts exceed the value of your assets, include IRS Form 982 with your tax return. You can download the form off the IRS's website at www.irs.gov. Completing it is not difficult.

Thinking Twice Before Settling

Before accepting what sounds like a deal, have a tax preparer calculate your tax liability. If your tax bill will be too high and you cannot prove you are insolvent, you may be better off filing for bankruptcy and discharging the entire debt, if possible.

If you plan to file for bankruptcy and want to include a debt that a creditor has settled or written off, talk to a bankruptcy lawyer -- preferably one who knows tax law. Some lawyers have concluded that on the day the creditor settles or writes off a debt, a "taxable event" occurs. This means that if you file for bankruptcy after that date, you cannot wipe out the debt unless your tax debt could be wiped out in bankruptcy. Other lawyers feel that the taxable event occurs on April 15, when your taxes are due, and that you can file for bankruptcy and wipe out the debt before that date, assuming it otherwise qualifies to be eliminated in bankruptcy.