If you thought your money woes ended last year when you settled that credit card, think again.

Avoiding 1099-C tax problems

What you should know: Have you negotiated with a creditor to pay less than you owe on a credit card debt? The IRS considers forgiven or canceled debt as taxable income.
What to do: Experts advise consumers to seek tax advice before negotiating credit card debt settlements to avoid a "surprise" tax hit from cancellation of debt.  

For many consumers with debt problems, after the debt collector leaves their lives, the taxman arrives.

Months after successfully resolving credit card debts, consumers have received 1099-C "cancellation of debt" tax notices in the mail. Why? The U.S. Internal Revenue Service considers forgiven or canceled debt as income. Creditors and debt collectors who agree to accept at least $600 less than the original balance are required by law to file 1099-C forms with the IRS and to send debtors notices as well. Taxpayers must report that "income" on their federal income tax returns.

"A lot of people don't realize they have any tax issues at all when they are going through this," says Alison Flores, a researcher at The Tax Institute at H&R Block, the nation's largest tax preparation service. "They say 'I'm really poor, I'm broke and I can't pay my bills. How can you consider this income?'"

It is, according to the Internal Revenue Code. For example, a person with $10,000 in credit card debt who negotiates to pay only $6,000 of the balance would have $4,000 in forgiven debt income. That $4,000 must be reported as "other income" on Line 21 of the 1040 tax form. Depending on the amount of debt forgiven, the taxpayer's income level, deductions and other factors, the consumer could face a sizable tax bill come April 15.

Surprise tax problem

The problem: Many consumers have no clue what the 1099-C forms are, and some may be trashing the cancellation of debt notices because the forms are sent by creditors or debt collectors with whom they thought they no longer had business. Still others are not filing the 1099-Cs with their federal income tax returns -- putting taxpayers at risk for IRS audits, penalties and fines. Consumer credit counselors and tax attorneys say few consumers are aware of the tax implications of settling to pay a lesser amount than they owe in credit card debt.