The IRS considers that debt that is canceled, full or in part, to be taxable income to the debtor to the extent the financial position of the taxpayer has been improved by the debt cancellation. This means that a credit card company settlement can result in an income tax bill from the Internal Revenue Service. It is even possible for the IRS to charge a tax when your house is foreclosed if the value of the house is less than the amount of the mortgage debt.
There are some solutions to this problem. First, in the case of a home foreclosure, if all the debt secured against a personal residence was used to buy or substantially improve the house, The Mortgage Forgiveness Debt Relief Act of 2007 offers protection from tax. Second, in all debt cancellation situations, to the extent you owe more debt than the total value of all of your assets, the canceled debt is not considered income for tax purposes.
However, the best alternative to avoid tax on cancelled debt may be bankruptcy. Debt that is canceled in a bankruptcy case is not considered to be income to the bankrupt debtor. The Internal Revenue Code 108(a)(1)(A) excludes debt discharged “in a title 11 case” from the taxpayer’s gross income. Title 11 of the US Code is the federal law on bankruptcy.
