When someone cancels a debt you owe, the IRS takes the position that it's income. But you can avoid paying taxes on it if you can prove that you’re insolvent.
When someone cancels or forgives a debt you owe, it can be something of a double-edged sword. Although you're free of the obligation, 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 type of debt might be canceled, such as a credit card or even a personal loan. The lender cancelling the debt is obligated to send you and the IRS Form 1099-C when a debt is forgiven. The form lists the amount of the canceled debt in box 2 and the amount of interest included in that amount in box 3.
You only have to include the interest amount as income on your tax return if it would have been tax deductible had you paid off the loan. Otherwise, you can subtract it from the number in box 2 and report the balance.
In the case of a short sale, you would have $25,000 in canceled debt if your mortgage balance was $175,000 and you sold the property for $150,000. 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.