Basics first: When a personal debt is canceled, the debtor is deemed to have received taxable income equal to the amount of canceled debt.

When both interest and principal are part of the debt, any settlement made to cancel the debt is considered principal.

Example: Joe Smith owes a bank $50,000, of which $35,000 is principal and $15,000 is accrued interest. When Joe settles the debt for $10,000, the IRS will tax him on $25,000, the amount of the forgiven debt--excluding the interest.

Warning: The IRS keeps strict tabs on canceled debts. When banks, brokerages, or other financial institutions forgive a loan, they are required to report the amount forgiven to the IRS using Form 1099-C. The IRS cross-checks the information on this form against the taxable income a person reports on his income tax return.

Loophole: Bankruptcy. When a debt is canceled as part of a bankruptcy filing, the debtor doesnt have to recognize any taxable income.

Example: If a taxpayer owes $13,000 on an installment loan, filing for bankruptcy lets him avoid paying tax on the $13,000 that is canceled.

Loophole: Insolvency. When a debtor doesnt file for bankruptcy but is financially insolvent both before and after the debt is canceled, he is not deemed to have received any taxable income.

Financial insolvency means that a persons total liabilities exceed his total assets.

Loophole: Undeducted debt. When debt is incurred for a business purpose that would normally be deductible, but the taxpayer does not take the deduction, he doesnt have to recognize any income when the debt is canceled.

Example: Joe owes $30,000 on credit cards, of which $20,000 went to pay for business expenses that could have been deducted, and the remaining $10,000 was used to pay personal expenses. When Joe repays $10,000, that amount should be allocated to the personal portion of the debt. The $20,000 of the debt that was canceled is not considered income because Joe did not take the business deduction to which he was entitled.

Loophole: Intrafamily loans. When money is owed to relatives or family members and the loan is really a gift, no taxes are due when the amount is not repaid.

How can one distinguish a loan from a gift? Generally, gifts are made without expectation of repayment.
Moreover, no interest is charged, or the interest rate is unreasonably low, and no substantial documentation exists. With a loan, on the other hand, repayment is expected and interest is charged.

Trap: When money is given, and its considered a gift, the lender could owe gift tax on the amount of the principal plus any imputed interest payments.

Loophole: When IRS threatens to seize IRA. When a person owes money to the IRS, and it seizes his IRA account, the amount withdrawn from the IRA is considered a distribution, subject to income tax.

Before the IRS can seize the IRA, the taxpayer should instruct the IRA trustee to distribute the balance in the account to him after withholding the expected taxes and any penalty.

This way, the taxpayer wont increase his current liability to the IRS by owing taxes on the withdrawal from the IRA. This allows him to try to negotiate an offer in compromise to settle his original IRS debt.
Offers in compromise are invalid unless all current taxes have been paid.

Example: A taxpayer owes the IRS $25,000 and has an IRA worth $10,000. The IRS seizes the IRA. The taxpayer now owes the IRS $15,000 from the original debt plus an extra $3,800 (assuming 28% tax bracket plus 10% penalty) in taxes on the money taken from the IRA. (The taxes are due the following April.)

If, instead, the taxpayer takes a $10,000 distribution from the IRA, and asks that the IRA trustee withhold the $3,800 in taxes, he will own the IRS $17,800 ($25,000 minus $7,200 from IRA) on the original debt and nothing will be due next April. So now he can try to negotiate an offer in compromise with the IRS to settle the entire past-due debt.

Loophole: For responsible persons. A corporate officer or other person responsible for unpaid corporate trust fund taxes (employee withholding taxes) should pay the money that should have been sent to the IRS to the company and have the company pay the IRS.

Reason: When a taxpayer pays money directly to the IRS from his personal account, it cannot be deducted. But when the taxpayer pays the corporation, he may be entitled to a write-off in the future.

Loophole: Interest paid on borrowed money is deductible-- or not--depending on how the loan proceeds are used.

Mortgage Interest. Interest on home mortgages up to $1 million used to buy, build, or substantially
improve a principal residence or a second home, is fully deductible.

Points paid to the bank to get the loan are deductible for principal homes.

Mortgage points on loans used to finance a second home or to refinance a first mortgage must be amortized.

Interest paid on a refinanced mortgage is deductible only to the extent it replaces the existing mortgage.
None of the interest paid on the refinancing that exceeds the amount of the original mortgage can be
deducted.

Loophole: Home-equity Interest. Interest is deductible on home-equity loans of up to $100,000.

Interest payments on a home equity loan are deductible no matter what the borrowed funds are used for.For instance, home-equity loans can be taken to pay off credit card debt, which would not normally by deductible.

Loophole: Investment interest carryover. Interest on money borrowed to make investments is deductible to the extent of a taxpayers investment income, which includes short-term capital gains, interest and dividend income, and some royalty income.

Caution: In the years a person suffers large stock market losses, its possible that even with substantial dividend income he may have no net investment income. Thats because short-term losses and investment adviser fees reduce a persons investment income.

In such a situation, the taxpayer can carry forward his investment interest and deduct it in subsequent years. TH