If you’ve been drowning in debt and your creditors throw you a lifeline through debt settlement, this can seem like the answer to all your problems. However, all that debt doesn’t just disappear once it’s settled. In fact, the government considers it taxable income and you may be in store for a nasty surprise at tax time when Uncle Sam comes to collect.

Why Is a Debt Settlement Considered Taxable Income?

You may be astonished or outraged when you discover that the government considers your forgiven debt to be taxable income, but there is logic to it. Debt is money that is given to you in lieu of a promise to repay. When you are unable to pay back that debt, then the debt transforms into money that someone gave to you. This, by definition, is taxable income. The fact that you’ve already spent this income doesn’t matter to the IRS.

What Portion of Debt is Considered to be Taxable?

Any amount of debt that has been canceled can be considered to be taxable income. If you run up $12,000 in debt and pay $2,000 of that back, the $10,000 difference is taxable. This can add as much as $1,500 to your tax bill. Of course, this rule only applies to the principal, or money that you actually got from the lender. Your interest isn’t figured into this because it’s not money you received.

How is the Canceled Debt Reported to the IRS?

Whenever a creditor cancels a debt amounting to more than $600, a form 1099-C must be filed with the IRS. The nature of the debt is described on the form and how much of the debt is canceled. This form is also sent to the debtor. Of course, even if your lender doesn’t send a 1099-C to you, you still have to report any settled debt on your tax return under the designation “Other Income” on Federal Tax Form 1040. If you need help figuring out which forms to file, you can try a service like H&R Block that has experience with all kinds of tax laws.

Are There Exceptions to Paying Taxes on Settled Debt?

There are a couple of exceptions when it comes to avoiding paying taxes on a debt that is settled. If you’re especially charming, you might be able to persuade your creditors to treat the forgiven debt as a gift. Of course, this rarely happens. The other available option is to prove you were financially insolvent prior to when your debt was settled. This essentially means that your assets were less than the total amount that you owed to the lender. If you go with this choice, you have to file a Form 982 with your tax return.

If you do have settled debt to report on your tax return, it may be to your advantage to seek the advice of a qualified tax professional. It’s one thing to owe money to creditors and quite another to owe money to the IRS. Ensuring that you’ve filed your taxes properly is especially important if you’re dealing with settled debt.