Many people do not realize that if they negotiate with a creditor to reduce the debt they owe, they might be imputed income for the amount of the reduction.
In other words, if you have a debt you cannot pay, and the creditor writes it off, you might receive a 1099 stating that you have income in the amount of the forgiven debt.
This gets reported to the IRS, and, if an exception does not apply, it will expect you to pay taxes on it.
There are exceptions, though, and in many cases these exceptions are helpful. For instance, discharge in bankruptcy is not taxable.
In addition, forgiven debts on principal residence are, in many cases, not taxable. The Mortgage Debt Relief Act of 2007 allows $2 million of forgiven debt on a qualified principal residence ($1 million if married filing separately).
Also, if you were insolvent at the time of debt forgiveness, the amount is not taxable. Being insolvent means that your total debts exceed your total assets. This calculation can become complicated by the fact that you may recognize a reportable capital gain even if you are insolvent. The IRS provides worksheets to calculate insolvency.
When attempting to work out debt reduction, if the amounts are substantial, it is a good idea to have a tax professional review the proposed plan prior to making it final. Strategic planning can often minimize the tax bite.
Some additional information from the IRS: