In many ways, debt is a lot like a zombie. No matter how many times you try to kill it, it finds a way to come back to life. Case in point, if a creditor cancels a debt you owed, you may liable for paying taxes on the amount that was eliminated. Here's what you need to know about this issue to keep it from taking a bite out of your financial future.

Cancelled Debt Must Be Reported as Income

Whether you defaulted on a loan or negotiated a reduced repayment with the creditor, the amount written off must be reported to the IRS as income. At first glance this may seem bizarre, like the tax agency is trying to squeeze every penny it can from your bank account. However, when you take out a loan or get a credit card, the bank is basically advancing you money. When you don't have to pay that money back, the IRS looks at the transaction as if the bank just issued you a paycheck or dividend payment and wants to ensure it gets its cut of that money.

If the creditor cancels $600 or more worth of debt, it must issue you a 1099-C form, though all amounts—including those under $600—must be reported to the IRS. Even if the creditor doesn't send you this form, it may report the cancelled amount to the tax authority, so you should keep track of debts that are written off by creditors and report them on the relevant tax returns. If you fail to do this and the creditor has notified the IRS it wrote off your debt, you may receive a notice from the tax agency directly stating you owe money for the amount that was written off.

Tax Liability for Repossessed Properties

Debt secured by property that is repossessed by the lender may also be subjected to taxation. However, the tax on this debt is handled a little differently depending on the property that was reclaimed. In general, you will be responsible for paying taxes on any amount still due on the loan after the lender has sold the property to recoup its losses. For instance, the amount of your car loan was $10,000 but the lender sold your repossessed vehicle for only $8,000. You would owe taxes on the $2,000 difference.

There is one exception to this rule in the case of foreclosed homes. If the mortgage was for your principal residence and you used the money to purchase, build, or improve the property, up to $2 million of any deficiency owed can be excluded from this reporting requirement. This only applies to foreclosed debts canceled between 2007 and 2014 though.

Times When You Don't Have to Pay Taxes

In addition to the exception made for some foreclosed homes, there are times when cancelled debt is not subject to taxation. The following debts are excluded from the mandatory income reporting:

• Those that would be tax deductible if they had been paid
• Certain student loans
• Gifts, bequests, inheritances, or devises that would be excluded from income reporting by law
• Those resulting from qualified price reductions provided by the seller
• Reductions in the mortgage principal resulting from pay-for-performance payments associated with the Home Affordable Modification Program
• Qualified farm, real property business, and principal residence debts

Most importantly, debts that are discharged via bankruptcy or cancelled during times when you were insolvent are also non-taxable. For instance, if your income was $25,000 per year but you had $50,000 worth of debt at the time, you wouldn't have to pay taxes on any amounts written off by the lenders. However, you would need to show the IRS that your finances were upside down at the time the debt was cancelled.

Like a double tap to the brain can keep a zombie from rising again, filing bankruptcy can permanently eliminate most of your debts and keep them from finding a way to reanimate. If you're struggling financially, contact a lawyer like John G Rhyne Attorney At Law for information about or assistance with filing for chapter 7 or chapter 13 bankruptcy.