Bills are piling up to the point where you dread opening your mailbox. If only your creditors would forgive your debt.
Sometimes, they will -- but even then your money troubles might not disappear.
Canceled debt in many cases is considered income -- taxable income. And if a creditor forgives thousands of dollars of debt, you can find yourself whacked by a big tax bill.
And that is not the only consequence. Forgiven debt can raise your income to the point where you're ineligible for certain credits and tax deductions, or part of your Social Security benefits is taxed, says Bob Scharin, a senior tax analyst with Thomson Tax & Accounting.
Of course, having a creditor absolve you of debt can be a financial lifesaver. And not all canceled debt is taxable. Congress last year, in response to the subprime mortgage mess, temporarily exempted a sizable amount of forgiven mortgage debt from taxes. Also, you won't be taxed on canceled debt in cases of bankruptcy or insolvency.
Still, a tax bill isn't what many expect when debt is being erased.
"People definitely are initially shocked," says Robin McKinney, executive director of the Maryland CASH Campaign, which helps lower-income taxpayers file returns. McKinney says she sees many such cases of shock now with car loans. The cars are repossessed and the loan balances wiped out, yet consumers receive a form saying they owe taxes on thousands of dollars of forgiven debt.
"Some people have even said, `If I had known this was a consequence, maybe I would have tried harder to refinance the loan,' " she says.
Credit-card bills are one of the most frequent types of forgiven debt -- and it is taxable.
Scharin notes an instance in which a consumer owed $21,270 on his credit card in 2004. The issuer, MBNA America Bank, agreed to accept about $4,600 to settle the debt. But the consumer balked at paying taxes on the $16,670. He argued that the settlement was a retroactive lowering of his interest rate and that he had repaid the principal. A tax court this month ruled against him.
Home mortgage debt is another area where many are trying to negotiate relief. Given the rise of foreclosures, Congress granted a temporary tax break for those whose housing debt is wiped out.
Under the new law, you won't have to pay taxes on up to $2 million of forgiven debt on a primary residence. Any debt wiped out on a second home is still subject to tax.
