If you have had a debt settled or forgiven that is greater than $600, most likely you will be receiving a 1099-C from the IRS.  Do you have to pay additional tax?

Here are a few tips to avoid paying any additional tax on settled or forgiven debts.

Anytime a creditor accepts less than the full balance due on an account, the IRS calls this a "forgiveness".

If this amount is greater than $600, the creditor most likely will report the amount to the IRS in order to write off a loss against their profits in order to minimize taxes, etc.

You would be mailed a 1099-C form that states that the creditor is claiming they "forgave" a certain amount of debt and therefore you must include the amount of forgiven debt as additional income.  This most likely will increase your taxable income and you would then be required to pay more tax.

OK...sounds bad, but hold on a second!

IRS publication 4681 explains (well this is a government document, so good luck) how to determine if you have to pay additional tax on the forgiven amount reported on the 1099-C.

At the bottom of page 5, under the paragraph heading "INSOLVENCY", the publication states:

"Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation.  You were insolvent immediately before the cancellation to the extent that the  total of all of your liabilities was more than the FMV (Fair Market Value) of all of your assets immediately before the cancellation.  For purposes of determining insolvency, assets include the value of everything you own..."

The publication goes into more detail and sites several examples, but the main point simplified is:

When the portion (or all) of the debt was forgiven, if you added up all of your NET ASSETS and subtracted all of you LIABILITIES OR DEBTS, did you have more LIABILITIES than ASSETS?

If so, then you will not include the forgiven amount as additional taxable income.

So how do you report this on your tax return?

Unfortunately, many tax preparer and/or accountants either do not understand or are too lazy to investigate how to handle a 1099-C presented by their clients!

So, every year, I have to help a tax preparer or accountant understand this exception and how and what forms to file.

My office partner is a tax preparer and provided me with an actual letter from an IRS Tax Examiner about dealing with the 1099-C issue.  In the letter, it states:

"Claims of insolvency must be supported by a listing of assets and liabilities at the time the debt was cancelled.  You may include a Form 982 or a simple cover letter claiming the insolvency and referencing the required listing."

This client made a handwritten lists of her assets on one side and the liabilities on the other.

Example:

As you can see, in this example, her Liabilities were greater than her Assets at the time of the "forgiveness". 

We have found that it is best to complete IRS Form 982 along with a copy of the Asset vs. Liabilities worksheet above and a brief letter that explains your financial hardship at the time of the forgiveness to submit with your tax return.

Conclusion:

Most people that have faced, or are facing, severe financial challenges may have some or all of a debt or debts settled or forgiven.  If this happens to you, follow the examples above to avoid paying unnecessary tax!

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