As a result of the economic crisis of recent years, many American taxpayers have applied for and received cancelation of some debts such as mortgages, car loans, and credit card bills. One thing that some citizens may not know, though, is that their canceled debt may be subject to income tax by the IRS. While the tax bill they get at the end of the year may be considerably less than the debt that was canceled, it may still put a strain on the household budget. The best way to prepare for this is to speak with a tax professional to find out if your canceled debt is taxable well in advance of the income tax deadline.

Which Canceled Debts are Taxable to the IRS?

According to the IRS, most personal and consumer debt cancelations are subject to income tax. One of the most common types of these debt cancelations is personal credit card debt. If you are able to convince your credit card company to write off most of your balance, you'll likely have to include the forgiven amount in your gross income for the year and pay tax on it. Another commonly canceled debt that is taxable is medical expense debt. For example, if you have an account balance that you're paying for previous hospital services, the hospital may offer you a debt reduction arrangement that drastically cuts the amount you owe. The IRS commonly requires that the amount of this forgiven medical debt be included in your gross income.

Do You Qualify to Exclude Your Canceled Debt?

However, several kinds of debt cancelations are expressly excluded from taxation. These include select student loan debt cancelations, any debt that is forgiven during bankruptcy proceedings, business debts that are forgiven, and farm debts that are canceled. Normally, the IRS would require taxpayers to include their forgiven mortgage debt in their gross income, but the government has allowed for an exception to this rule in the Mortgage Forgiveness Debt Relief Act of 2007. Under this provision, homeowners can exclude up to $2 million of mortgage debt that is forgiven by their lenders from their gross income for the year.

The relief that comes with getting a large amount of debt canceled can quickly be replaced with worry about how to pay tax on this amount. If you find out whether your canceled debt is eligible for exclusion from tax, you can save yourself unnecessary stress when it's time to pay your tax bill.