The IRS may count a debt written off or settled by your creditor as income to you.

An IRS law could cost you money if you settle a debt with a creditor for less than the full amount. Likewise, this rule could shrink your wallet if a creditor writes off a debt you owe -- that is, ceases collection efforts, declares the debt uncollectible and reports it as a tax loss to the IRS. (26 U.S.C. § 108.) This is because you must report forgiven debt as income, with certain important exceptions. Debts subject to this law include money owed after foreclosure or property repossession or a credit card bill you don't pay.

Any financial institution that forgives or writes off $600 or more of a debt's principal (the amount not attributable to interest or fees) must send you and the IRS a Form 1099-C at the end of the tax year. These forms are for the report of income, which means that when you file your tax return for the tax year in which your debt was settled or written off, the IRS will make sure that you report the amount on the Form 1099-C as income.

There are several exceptions stated in the Internal Revenue Code. For example, if the financial institution issues a Form 1099-C, you do not have to report the income on your tax return if:

• the cancellation or write off of the debt is intended as a gift (this would be unusual)
• you discharge the debt in bankruptcy, or
• you were insolvent before the creditor agreed to settle or write off the debt.

Insolvency means that your debts exceed the value of your assets. To figure out whether or not you were insolvent, you will have to total up your assets and your debts, including the debt that was settled or written off.