When you are in debt, the creditor holding the debt has many options when it comes to collecting the balance. While the creditor could file a lawsuit against you or place a lien on your property, sometimes the creditor simply cancels the debt and moves on. When this happens, it eliminates the amount that you owe.
Canceled Debt
In some situations, creditors will simply cancel outstanding debts and write them off. This means that the creditor forgives the amount that you owe, and no longer expects you to pay it. This is common when negotiating a debt settlement. As part of the debt settlement process, the creditor accepts a one-time lump-sum payment, and then cancels the remainder of the debt amount. Once the debt has been canceled, the creditor can no longer legally try to collect it.
Tax Consequences
Although it may be attractive to have part of your debt eliminated, it can create an unwelcome surprise during tax season. The amount of money that is canceled by your creditor is counted as income by the Internal Revenue Service. The creditor will send you and the IRS a 1099-C form, showing how much money you earned in this transaction. Although you did not physically receive any money, you "earned" money by having eliminated debt which will never have to be repaid.
Real Estate
If your home is foreclosed upon, the lender will try to sell your house in an auction. If the house does not sell for as much as you owe on your mortgage, then a deficiency is created. In many cases, the lender simply chooses to cancel the debt. With other debts, this would create a tax liability, but you will not have to pay taxes on this income. The Mortgage Forgiveness Debt Relief Act makes it so that you do not have to pay taxes on that amount. This provision is available for debt forgiven between the years of 2007 and 2012.
Rental Property
If you own a rental property and lose it to foreclosure, this could create a tax liability. The Mortgage Forgiveness Debt Relief Act does not provide any help unless you are dealing with your primary residence. Rental properties, second homes and any other real estate does not get protection through this act. This means that when you lose a secondary home, the canceled amount is counted as taxable income, which is added to your other income for the year when determining how much you owe.
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