How to Report Cancelled Debts on Tax Returns

Protesters carry a banner calling for Detroit's debt to be cancelled as people enter the federal courthouse for day one of Detroit's municipal bankruptcy hearings in 2013.
© REBECCA COOK/Reuters/Corbis

When the economy is in a downturn, many people find themselves in debt of some kind. Mortgage debt, credit card debt, student loan debt -- it all adds up, and sometimes you just can't pay it all, no matter how hard you try.

If you default on a debt, after a certain number of years the creditor declares the debt uncollectible and reports it to the IRS as lost income. The same happens if your debt is forgiven, you abandon the property, settle a debt for less than it's worth, sell your home in a short sale, or if your property is repossessed or foreclosed upon.

Unfortunately, the IRS still wants to collect tax on this lost income, and guess who they'll come looking for? You. Here's why: Because you don't have to pay this debt anymore, the IRS looks at it as gained income, and they want their piece of the pie. Think of it as "phantom income." It might seem unfair, but it's the law, and ignoring it can have dire consequences. Thankfully there are plenty of exceptions.

Keep reading to learn more about cancelled debt and how to properly report it on your tax return.