For anyone who's ever been in a serious debt, getting the credit card company or any other creditors to reduce or even cancel your debt seems like the best thing that could ever happen to you and your family. You record will be clear, and you no longer will have the burden of all that debt hanging on your shoulders. Often, people don't realize that if they're not careful, and don't prepare properly, then they are actually setting themselves up for a potential IRS problem. The fact is, the IRS considers the reduced or cancelled debt as taxable income, hence, you will be required to pay taxes on this. So the next time you avail of this benefit, make sure you understand that you'll be partly indebted to the IRS for this. This is among the basic guidelines regarding cancelled or reduced debt.

A number of years ago, getting a loan or having credit card applications approved was relatively easy. As a result, many people become impulsive buyers and irrational spenders. Unfortunately, people forget the fact that they need to pay for all these debts.

In reality, however, banks cannot put people in jail merely because of massive debt. In many cases, banks and other creditors hire a specialized collections firm so the latter will be the ones to collect from delinquent payers. That firm will get compensated on the amount that they have actually collected from the debtors. Now, back on the impact of a reduced debt on your taxes. Hypothetically speaking, if you had $20,000 in debt, and you negotiated it down to having to pay only $10,000 with the rest being erased, then the IRS would treat that $10,000 reduction as income. This benefit will be added to your taxable income and in effect, you'll owe the IRS more taxes.

You can't get away from paying taxes on a tax reduction as a copy of your Form 1099-C will be forwarded by your creditors to the IRS. This entry will be reflected on line 21 of tax Form 1040 because this will qualify under 'other income.' The problem becomes more evident because you'll now be required to pay a huge percentage of the $10,000 to the IRS. This is aside from having to pay for your regular and state taxes. This scenario is a good example of why first and foremost, there's a need to understand the implications of a reduced debt. Your debts to your creditors maybe erased, but these are transferred to the government. One thing remains: you're the still the one who will pay for those debts.

Unlike regular creditors, the government can send you to jail if you consistently do not pay your taxes. It is a good thing, however, that certain measures are available to help those who are in need. For instance, if the creditor of your home forgave $100,000 from your total debt of $200,000, naturally, $100,000 will be reported to the IRS as part of your 'other income.' Having to pay taxes on such a substantial amount of money is more likely to put you in trouble with the IRS. Fortunately, by 2007, Congress has passed a policy stating that any tax reduction of up to $2 million and that is attached to your primary residence, will be excluded from our 2007, 2008 and 2009 tax returns. Hence, in the example above, you'll be exempted from paying taxes on the $100,000 tax reduction because of this new stipulation. On another light, the government also provides several remedies for tax payments on reduced debt. It is best that you refer to a tax professional first before availing any of these procedures.