When someone cancels or forgives a debt you owe, it’s something of a double-edged sword. You’re free of the obligation but the Internal Revenue Service might come knocking at your door. The IRS takes the position that if you borrow and accept money that you don’t have to pay back, it’s income. But you can avoid paying taxes on it if you can prove that you’re insolvent.
Determining Canceled Debt
A classic example of canceled debt is the short sale of a home: You sell the property for less than the mortgage against it and your lender writes off the difference. But any debt might be canceled, such as a credit card or even a personal loan. The lender cancelling debit is obligated to send you and the IRS notice (Form 1099-C) when a debt is forgiven, listing the amount of the canceled debt (box 2) and interest included in that amount (box 3). You only have to include the interest amount as income on your tax return if you couldn’t have deducted the interest payments had you kept on paying the loan. Otherwise, you can subtract it from the number in box 2 and report the balance. In the case of a short sale, if your mortgage balance is $175,000 and if you sell the property for $150,000, you’ve got $25,000 in canceled debt; this translates into an additional $25,000 in income for that year, unless you can prove you’re insolvent.
You can determine whether you’re insolvent by adding up all your debts -- not the monthly payments but the overall outstanding balances -- and totaling the fair market value of all your assets. Don’t neglect to include assets that debtors couldn’t ordinarily touch, such as retirement accounts. If your debts exceed the value of your assets, you’re insolvent. You must assess your debts and the value of your property as of the time the debt was forgiven, not at tax time. This might give you an edge if you’ve since bounced back from your economic woes -- you might not be insolvent in your current financial condition, but you were back when the debt was canceled.
Claiming Canceled Debt
If you’re insolvent, you can subtract the extent of your insolvency from the amount shown in box 2 of the 1099-C. For example, if your debts total $200,000 and the fair market value of all your property is $175,000, the extent of your insolvency is $25,000. If the canceled debt listed on your 1099-C is $25,000 or less, you don’t have to claim any of it as income. If the extent of your insolvency is only $10,000, you would only have to declare as income and pay taxes on $15,000.
The final hurdle is convincing the IRS that you were insolvent at the time your debt was canceled. To do so, you must complete and file Form 982 with your tax return. Check the box that says “Discharge of indebtedness to the extent insolvent,” which appears at line 1b. You don’t have to do anything else, but, to avoid the IRS questioning your claim, complete the insolvency worksheet, showing how you arrived at the number. You can find the worksheet on the IRS website on page 8 of Publication 4681. Keep copies of the statements and appraisals you used to fill out the worksheet in case the IRS isn’t satisfied with your calculations.