The cancellation of debt can be of great benefit to people who are in over their heads with unmanageable financial obligations. After years of struggling, getting rid of old debt can allow people to make a new fresh start.

However, it is important to remember that canceling debt isn’t a free pass. The IRS views canceled debt as income, so in many cases a debtor will have to pay income tax on the value of the canceled debt. Tax consequences are especially likely in cases where people use a debt management service to settle their debts without filing for bankruptcy.

There are several exceptions to this rule. There are some tax-free ways to get out of debt. Some of the more popular tax-exempt discharge strategies include the following:

• Bankruptcy: Cancellation of debt under Chapter 7, Chapter 11 and Chapter 13 bankruptcies is exempt from federal income taxation.
• Insolvency: If the debtor is considered to be “insolvent” before the cancellation occurs – that is, if the debts exceed the fair market value of the debtor’s assets – the cancellation of debt will not be taxable to the extent of the insolvency. Usually, in these cases, only a portion of the canceled debt will be exempt from taxation.
• Home Mortgages: Special legislation made the cancellation of mortgage debt exempt from income taxation, but only through the end of 2012. Debtors do not need to be insolvent or declare bankruptcy in order to take advantage of this exemption.
• Interest: Interest that would have otherwise been deductible (like home mortgage interest) is exempt from taxation if it was unpaid and added to the value of the cancelled debt.

Of course, these are only broad principles. Every debtor’s situation is unique. For that reason, it is always wise to seek the advice of an experienced bankruptcy attorney before trying to cancel your debt.

Source: Smart Money, “How Wiping Out Debt Affects Your Taxes,” July 31, 2012.

For more information on dealing with unmanageable debt, please visit our bankruptcy page.