Compromised Debt

• Compromised debt is literally debt over which a lender and debtor have reached a compromise. This often means that the debtor cannot make payments on the original terms of the loan, so the lender agrees to change it in order to recover at least some of the money owed. A common solution is debt forgiveness. The lender agrees to forgive a portion of the principal owed by the individual to make the debt more manageable. The new terms then apply to the loan for the rest of its life.
  
  

Income Tax Creation

• Forgiven debt during a compromise falls under an unusual category. While the debtor does not actually receive money, it negates a debt that would have otherwise been paid, and the IRS considers this to have the same effect as receiving income. As such, the individual must pay taxes on it according to the proper income tax level. Government taxes are one of the most important obligations that follow an estate if the individual that created the obligation died.
  
  

Exemptions

• There are many exemptions to this income tax from compromised debt. Government programs allow tax-free forgiveness for home loans during times of economic stress. Also, if the individual filed as insolvent -- usually accompanied by a bankruptcy -- then the tax is no longer applicable for the forgiven amount. Also, debt forgiveness directly associated with a bankruptcy, certain types of farm debt, debt from various disasters and other discharges of debt do not incur the tax at all.
  
  

How Forgiven Debt is Counted

• How the forgiven debt is counted by the IRS can also make a difference as to how it is treated when it comes to income tax. For example, in the late 1990s in Tennessee, an estate had taxes incurred from the forgiveness of debt that was treated as a dividend by the estate. The estate had to pay federal income taxes according to the dividend rates, but the amount did not qualify for Tennessee state income taxes. These situations change from state to state and often case to case, based on the specifics.