How to Prove Insolvency With the IRS

By Beverly Bird - Updated June 20, 2017
Man working on a computer in home office

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.

Determining Insolvency

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

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.

About the Author

Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance, divorce and family law, bankruptcy, and estate law, and she writes as the tax expert for The Balance. She is the author of more than 30 novels.

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