Many consumers find themselves in over their heads with debts. Occasionally, some of these debts may be forgiven though various means. Working with a debt settlement firm or declaring bankruptcy are two ways that a debt may be “forgiven,” but there are other ways as well. This means that the debtor no longer owes the money to the creditor.
The result may mean financial relief for the consumer, but that relief can turn into a headache at tax time. That’s because creditors who forgive all or a portion of a debt are required to send form 1099-C to debtors. This form indicates that a debt has been cancelled. From the IRS’ perspective, the forgiveness of that debt means increased income.
Accordingly, the IRS expects the debtor to claim the amount of the cancelled debt as income on their tax return. Depending upon the size of the debt forgiven, or if multiple debts were forgiven, this can represent a steep tax bill.
Insolvency Makes Cancelled Debts Tax Exempt
If a taxpayer can prove that they are insolvent, the taxes due on the forgiven debt may be partially or wholly tax exempt. The IRS has created a form that you must file in order to prove that you are insolvent.
Form 982 is available from the IRS website. The most important component of the form is the box that says, “Discharge of indebtedness to the extent solvent.” No attachments or supporting documents are required. However, determining your insolvency will require filling out a worksheet that the IRS may ask for later.
You’ll find a worksheet within this publication that can be used to determine whether or not you are insolvent. Part one of the form is where you list all of your debts. Include any cancelled debts in part one as well as any debts that were not forgiven. Part two is provided so you may list your assets. There is no space for entering your annual income as this is not a consideration in insolvency. Rather, this worksheet is meant to provide a snapshot of your finances at one moment. You’ll include bank account balances and the value of any real estate or cars you own. You’ll also need to include any 401 (k) or other retirement accounts. Subtract the total assets from the total debts. Totals of zero or less mean that you are not insolvent.