Settling your credit card can be a way to get out of debt and save money. If you end up unable to pay your credit card bills and they sit long enough, the credit card company or the collector that assumed your debt from the creditor might be willing to take what it can get, even if it's less than what you owe in total. Sometimes, the credit card company or collector will take a partial payment and call the account paid off -- a settlement. When this happens, the Internal Revenue Service wants to know about it.

The Downside of Settlements

When you settle a debt, you essentially become better off. If you owe $2,000 and you convince your credit card company's collector to take $900, $1,100 of your debt disappears. To the IRS, that debt forgiveness is a form of income. Like just about every other income you get, you have to pay taxes on it.

1099-Cs and Your 1040

When you get a debt cancellation of $600 or more, the creditor sends a Form 1099-C to you and to the IRS. The 1099-C reports how much debt -- but not interest or fees -- was canceled. Whether or not you get a 1099-C, though, it's your responsibility to report your canceled debt on your 1040. Include it on line 21, assuming it's a personal debt. It then is added to your other income.

Finding Loopholes

You can get out of paying tax on canceled debts in two ways. One is to have them erased by filing bankruptcy. The other is to have them forgiven when you are insolvent. Insolvency means that you owe more than you are worth. For instance, if you have a car worth $4,000, clothing and household goods worth $7,000 and $1,000 in the bank, you have $12,000 worth of assets. If you owe $22,000 in student loans and $3,000 on your credit cards, you have $25,000 in debts and a negative net worth of $13,000. If you were to get your entire credit card debt canceled -- all $3,000 -- you would still have a negative net worth of $10,000. Because you would still be insolvent, you wouldn't have to pay taxes on the cancellation.

Beyond Your Return

Credit card settlements don't just affect your tax return, though. They also show up on your credit report. Settling your debt won't erase any negative information that was reported before you paid off the debt. In addition, creditors can report that you "settled" instead of "paid" your debt. This lets anyone who pulls your report see that you didn't pay your entire debt, and this person -- a potential lender or employer or landlord -- could hold it against you.