Bills are piling up to the point where you dread opening your mailbox. If only your creditors would forgive your debt. Sometimes, they will -- but even then your money troubles might not disappear. Canceled debt in many cases is considered taxable income. And if a creditor forgives thousands of dollars of debt, you can find yourself whacked by a big tax bill. And that is not the only consequence. Forgiven debt can raise your income to the point where you're ineligible for certain credits and tax deductions, or part of your Social Security benefits is taxed, said Bob Scharin, a senior tax analyst with Thomson Tax & Accounting. Of course, having a creditor absolve you of debt can be a financial lifesaver. Still, a tax bill isn't what many expect when debt is being erased. "People definitely are initially shocked, said Robin McKinney, executive director of the Maryland Cash Campaign, which helps lower-income taxpayers file returns. McKinney said she sees many such cases of shock now with car loans. The cars are repossessed and the loan balances wiped out, yet consumers receive a form saying they owe taxes on thousands of dollars of forgiven debt. "Some people have even said, 'If I had known this was a consequence, maybe I would have tried harder to refinance the loan, she said. Credit-card bills are one of the most frequent types of forgiven debt -- and it is taxable. Scharin notes an instance in which a consumer owed $21,270 on his credit card in 2004. The issuer, MBNA America Bank, agreed to accept about $4,600 to settle the debt. But the consumer balked at paying taxes on the $16,670. He argued that the settlement was a retroactive lowering of his interest rate and that he had repaid the principal. A tax court recently ruled against him.Home-mortgage debt is another area where many are trying to negotiate relief. Given the rise of foreclosures, Congress granted a temporary tax break for those whose housing debt is wiped out. Under the new law, you won't have to pay taxes on up to $2 million of forgiven debt on a primary residence. Any debt wiped out on a second home is still subject to tax. If the bank forgives the home-equity loan you used to make substantial improvements to the house, that won't be taxed, either, Scharin said. But if that home-equity loan was taken out for other reasons -- say, to buy a car -- then the forgiven debt will be taxed. Again, this tax break is temporary. It applies to mortgage debt forgiven last year and through 2009. Students, too, can catch a break. Many student-loan forgiveness programs are available if borrowers work in particular fields, such as nursing or teaching, after graduation. This debt relief is not taxed, Scharin said. Steve Hannan, executive director of the Maryland Consumers Rights Coalition, said negotiating for debt relief "is a good move, but you must realize the tax consequences. He advises consumers to obtain any settlement in writing and find out if the creditor will notify credit-reporting agencies that the debt is forgiven. "It doesn't do any good if the debt has been forgiven but nobody knows about it, he said. Keep all documentation to prove the debt was forgiven, in case a debt collector in the future tries to collect it again, he said. While credit-card debt generally is taxed, it won't be taxed along with any other debt that is canceled in cases of bankruptcy or insolvency. As for documents, if you have $600 or more of canceled debt, you will receive a Cancellation of Debt form, or 1099-C, for tax purposes. (Even if the amount is less than $600, you are expected to report it as other income on your tax Form 1040.) The IRS wants you to pay taxes on a pay-as-you-go-basis, McKinney said. If it looks as if you will owe a chunk of taxes on forgiven debt, you should pay estimated taxes on the amount or risk being hit with a penalty later, she said. If you don't have the money to pay the tax bill, you'll have to set up a payment plan with the IRS, she said. Debt purchasers and creditors are required to notify the IRS when forgiveness exceeds $600, thereby probably creating a tax liability for the debtor whose debt was forgiven. The rub comes when a debt purchaser has not been given adequate information to verify the breakdown of the debt between principal and interest/fees. The debtor does not owe taxes on forgiven interest/fees. Consequently, the amount reported as forgiven may be greater than the amount of principal forgiven, increasing the debtor' tax liability. The IRS form utilized for this purpose is the 1099-c. Of course a creditor who issues a 1099c should know the actual amount of principal forgiven, they are the only ones with their hands on the account. A contingency collector has no obligation to file a 1099-c. Only a debt purchaser must file without necessarily knowing the information required. This happens because not all debt sellers provide accurate information about the breakdown when they sell the account. This could all be solved if the IRS would define one term in their ruling: stated principal. The Service uses the term, but doesn't define it. DBA International and other trade associations have been working with Congress, the Treasury Department and the IRS for several years to seek this definition. With a definition of stated principal to which creditors must adhere when debt is sold, the debt purchaser would have the ability to report more accurately on IRS Form 1099-c. The IRS law on the issuance of 1099-c forms is to be found at 26 U.S.C. 2650-P. If you can prove that you have disputed the debt then you may be able to get out of having to pay the tax. The best form of dispute is to not only use a VOD letter but also to dispute it in court. And even better way is to catch them violating FDCPA, take them to federal court and in the process of the Rule 26(f) negotiations make them pay the debt for you. That way they can't claim they settled for less or that any of the debt was forgiven. If they do then they have filed a false return with IRS. Another way to potentially nail them again is to demand a strict non-disclosure clause with a steep penalty in the event that either party reveals any of the terms and conditions of the settlement to any third party unless it is ordered to do so by a court of law. If they report to any other party such as a CRA or the IRS you can sue them again for violating the terms and conditions of the settlement contract. The penalty should be as high as they will agree to. Start out with a $25,000 stipulated penalty in case of breach of contract. Count on the fact that they probably won't agree to such a high amount but you can always agree to less. Then once the settlement is all over with and agreed to by both parties your next move is to dispute it with the credit bureaus. If they report back to the credit bureaus then nail them again. If they are smart enough to realize that reporting to credit bureaus is a violation of the settlement agreement (unlikely they will be that smart) and don't report the listing comes off your credit reports by law. So the obvious lesson is to dispute the debt not only by VOD but by fighting in court and by filing against them in federal court. Now then, I think anyone would agree that fighting tooth and nail has to be better than incurring a huge tax liability you may not be able to pay any easier than you could have paid the debt. And it has to be many orders of magnitude better than any other credit repair tactic than you will find on any message board anywhere. And you don't even need a lawyer to do it. Learn how to do it yourself and make even more in the process. Found this article on my RSS feeds.