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The Costly Tax Trap of Debt Forgiveness

A lot has been written about forgiveness. Perhaps Mark Twain described it best: "Forgiveness is the fragrance that the violet sheds on the heel that has crushed it." But for our purposes, Oscar Wilde had the right perspective: "Always forgive your enemies--nothing annoys them so much." And that brings us to the tax consequences of forgiven debt.

This past week I met with my tax accountant. For more than an hour, he peppered me with questions in advance of preparing my tax returns. Most of the questions were predictable, but he surprised me with one: Has any of my credit card debt been forgiven?

As he explained, some of his clients have called their credit card company and asked for some of their debt to be forgiven. As part of a deal to pay the card off completely, some credit card companies have agreed. If you are overwhelmed by credit card debt, it's worth a phone call. You just may get some of your debt forgiven. But there's a catch.

Forgiven debt is, with some exceptions, taxable. So if a credit card company shaves off $5,000 of your bill, that amount is likely taxable at both the state and federal level. Of course, as with all tax matters, consult a tax professional to be sure. But the result can be a nasty surprise come tax time.

There are, however, a number of exceptions to the rule. Perhaps the most significant exception applies to mortgage debt. As part of a short sale, for example, a homeowner may have a substantial amount of his or her mortgage wiped away. Normally, this would be a taxable event. But with the decline in property values, the government enacted the Mortgage Debt Relief Act of 2007.

As the IRS explains, the Act "generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief." If you qualify, $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately), according to the IRS.

There are other exclusions, too. For example, forgiven debt is not taxable under the following circumstances (again, according to the IRS):

-- Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.

-- Insolvency: If you are insolvent when the debt is canceled, some or all of the canceled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.

-- Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your canceled debt is generally not considered taxable income.

-- Non-recourse loans: A non-recourse loan is a loan for which the lender's only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.

You can get more information on these exceptions from IRS Publication 4681.

Getting relief from overwhelming debt can put you back on track financially. But be alert to the potential tax consequences of loan forgiveness, as it could end up as taxable income on Form 1040. And as always, consult a tax professional for advice about your specific situation.

DR is the founder of the popular personal finance blog The Dough Roller, and the credit card review site Credit Card Offers IQ.

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