When someone cancels a debt you owe, the IRS takes the position that it's income. Although you didn't receive any money, you no longer owe the debt, and it's the same as if they gave the money to you. You can avoid paying taxes on canceled debt 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. So how do you show the IRS that you're insolvent?
TL;DR (Too Long; Didn't Read)
To prove insolvency to the IRS, you'll need to add up all your debts from any source, and then add up the value of all your assets. If you subtract your debts from the value of your assets and the number is negative, you're insolvent. You'll need to report this to the IRS on Form 982. Beware, though, that the IRS might flag it and seek evidence that your debts are what you say they are and that your assets are worth what you say they're worth.
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 creditors 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
Now 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 have to declare as income and pay taxes on $15,000.
Proving Insolvency to the IRS
The final hurdle is convincing the IRS that you were insolvent at the time your debt was canceled. You must complete and file Form 982 with your tax return to do so. 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 you might want to complete the insolvency worksheet, showing how you arrived at the number, to avoid the IRS questioning your claim. You can find the worksheet on the IRS website in 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.