Escape a debt, face the IRS

Congratulations. You just talked a lender into reducing or canceling a troublesome debt. The bad news? Now you may have a tax problem.

Did you get a credit card company to reduce your debt or even cancel it? Good for you. It's a huge relief for you and your family.

But don't congratulate yourself for too long. You may have a created a second problem that needs some careful planning. The amount of the debt reduction is taxable income, and you will owe money to the Internal Revenue Service.

Sorry, but that's the rule -- generally speaking. There are exceptions to the rule, and we'll get to those.

The problem begins with what, until recently, was the a great credit environment for borrowers. Banks were begging you to take their money.

If you couldn't qualify for a fixed-rate loan, you'd probably be offered an adjustable-rate loan, even now. And if you don't have enough cash for a 20% down payment, you can still get private mortgage insurance and go without.

In fact, if you take out a new mortgage with PMI, you may even be able to deduct the monthly premium from your income taxes.

As for credit cards, it was ridiculous. All three of my grandchildren were offered gold cards before their first birthdays. The banks were giving them away like prizes in a Cracker Jack box. I filled out applications for my dog and cat, and it turns out even they can get credit cards.

Or could until the credit crunch hit. In fact, with credit so easy, it's no wonder so many people got in trouble, falling behind on their mortgages and credit cards. Many people are so far behind they'll never catch up. Many, in fact, have just stopped paying.

A lender's deal will have a nasty bite

Fact is, your creditors really aren't your friends. But they understand that if you don't have any assets and have minimal cash flow, there's very little they can do. We don't have debtor prisons. In many cases, creditors almost automatically turn your account over to professional collectors, who get paid based on what they collect.

This gives you two opportunities to resolve your problem by paying less than the full amount of your debt. In both cases -- with the original creditor and with the collector -- they're willing to take whatever cash they can get.

I don't have a problem with cutting a deal with a creditor, but you have to know what you're getting into.

Based on your individual situation, you can offer to pay, say, 10% of what's owed. Your creditor probably won't take your first offer, so start low, but within reason. It's really a function of your cash flow and your assets. You can always increase your offer, but you really can't go down.

Explain where you'd get the money -- say, from a relative. But make sure the creditor recognizes there is a limit to how much you can borrow. Bank money is out of the question, because you failed to stay current on your debt.

The shock of the tax problem

Eventually, you'll get a deal. It may cost you your house and your credit score, but they can't get blood out of a stone. Part of your debt is going to get written off.

Swell, you say. You exhale a sigh of relief . . . until tax time.

That's when your former creditor sends you a Form 1099-C (.pdf file) showing the amount of debt relief. Your ex-creditor also sends a copy to the IRS.

• Video: Getting debt under control

Unfortunately, those rascals in Washington expect you to pay tax on the amount of that debt relief. It's other income, reported on line 21 of your 2009 federal Form 1040 (.pdf file).

Say you file jointly and have a taxable income (before the additional debt relief income) of $67,900. You're in the 25% bracket. If you settled a $20,000 liability for $10,000, that gives you $10,000 in additional income. Those additional dollars will be taxed at a rate no lower than 25%. Add state taxes, and they're reaching into your pocket for an additional $3,000 in taxes.

You couldn't afford to pay the minimum on your credit cards. Now the IRS wants a check for what you were grossing in total over the last six months.

Now here are the exceptions to this scenario. The first is really important.

Until December 2006, if your mortgage lender forgave, say, $100,000 of a $200,000 loan, you would be required to report that forgiveness as income. That would have caused astounding amounts of hardship for some people.

Congress decided that was too much. In late 2007, our lawmakers decided that debt forgiveness on your primary residence, up to a $2 million ceiling, escapes taxation for 2007-2012. So, if you had a $200,000 mortgage, and your lender agreed to forgive $100,000 of the balance, you won't have to pay any tax on the $100,000.

And there are other ways the debt-relief amount may be free of taxes.

The IRS isn't completely without a heart. There was a special provision that made discharged debt tax free to some victims of Hurricane Katrina. You also don't recognize income from debt forgiveness if you were the victim of a terrorist attack.

For those who don't qualify, there's another escape hatch. If the debt was discharged as part of a filed bankruptcy, then there's no income.

What if you didn't even have the cash flow to file a bankruptcy petition? If you were "insolvent" immediately prior to the debt discharge, you may also escape taxation on the debt relief. You're "insolvent" if your liabilities exceed your assets.

But -- and this is a big but -- this exclusion is limited to the amount by which you are insolvent. Say you have $50,000 in assets and $70,000 in liabilities. You're insolvent to the extent of $20,000. So if you have $30,000 in debt relief, $10,000 is still going to be taxable.

That brings to the installment agreement or the offer in compromise.

The IRS may cut a deal

This is a potentially painful dilemma. If you don't have the cash, you have two options:

• An installment agreement: This is an agreement to pay the tax bill over an agreed-upon time. You apply for that on Form 9465 (.pdf file). You will pay interest (currently 4%) on this agreement, but it's cheaper than the rate on a credit card.

• An offer in compromise: You apply for that on Form 656 (.pdf file). This is an agreement between you and the IRS that resolves your tax debt. The IRS has the authority to settle tax liabilities by accepting less than full payment under certain circumstances. A warning, however. The IRS is, frankly, very stingy on agreeing to these.

By Jeff Schnepper