Getting your debt reduced or cancelled is a major cause for celebration as your records will be clear and you’ll no longer bear the burden of paying for a large amount of money. Just remember that the government treats a reduced or cancelled debt as taxable income, and so you will be required to pay taxes on this. Remember that overlooking this fact will cause you to have an IRS problem as this is the general guideline pertaining to reduced or cancelled debts.

Until recently, it was so easy to accumulate credit. For the earlier part of the decade, several people could get loans and be approved for credit cards with relatively little difficulty. Many people spent uncontrollably and accumulate substantial sums of debt. Too much have they spent that they lose sight of their financial capability to realistically pay off their debts.

Banks know that they don’t have the legal right to send people to jail just because of a massive debt. This is why in some occasions, they hire specialized firms to take on the responsibility of collecting money from delinquent debtors. These firms will be paid by the banks on a percentage basis, depending upon how much they have collected from the debtors. Now, back to reduced or cancelled debts. Consider the case 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.

Because creditors will send the IRS a copy of your Form 1099-C, the latter will be informed of the debt reduction. This reduced debt will form part of your “other income” and this will be duly reflected in your tax Form 1040, particularly on line 21. In the above example, rather than paying to your creditors, you will now be paying a certain percentage of $10,000 to the government. In effect, having a tax reduction will result to more taxes as this new income will be added on top of your regular and state taxes.. This example clearly demonstrates why there’s a need to understand the effects of a tax reduction first prior to subjecting yourself into one.

Unlike regular creditors, the IRS can send you to jail if you consistently don’t pay your taxes. Fortunately, people are provided with remedies for this kind of situation. For instance, 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.” Having to pay taxes on such a substantial amount of money is more likely to put you in danger with the IRS. Fortunately in 2007, Congress has made a policy specifying that tax reductions amounting up to $2 million and attached to your primary residence are to be excluded from your 2007, 2008 and 2009 tax returns. Therefore, in the case above, you’ll be exempted from paying taxes on the $100,000 tax reduction because of this new law. On another light, the government also provides several remedies for tax payments on reduced debt. Before you avail of any of these, be certain that you have asked assistance from a tax attorney or a CPA.