How to Avoid Taxes on Canceled Debt (cont.)
Canceled Debt that Qualifies for Exception to Inclusion in Gross Income:
1. Amounts specifically excluded from income by law such as gifts or bequests
2. Cancellation of certain qualified student loans
3. Canceled debt that if paid by a cash basis taxpayer is otherwise deductible
4. A qualified purchase price reduction given by a seller
If you qualify for an exception or exclusion, you will have to fill out IRS Form 982. It may not be easy. The title of the form alone—Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)—is intimidating.
In fact, Olsen told Congress that “Form 982 is extremely complex, and very few taxpayers or preparers are familiar with it.” Here’s a look at two of the most common exclusions that may apply:
1. Debt canceled in a Title 11 bankruptcy case
You do not have to pay tax on debt successfully discharged in bankruptcy. (Title 11 refers to the section of U.S. Code that is referred to as the Bankruptcy Code. It does not mean only debts wiped out in a Chapter 11 bankruptcy qualify for this exclusion).
However, if you settled a debt before you filed for bankruptcy, the creditor may still send you a 1099-C indicating the forgiven amount, and you will have to research whether there are other exceptions or exclusions you can use to avoid paying taxes on that amount.
“We are seeing where some taxpayers have received 1099-Cs and they subsequently filed for bankruptcy,” says Dennis. “Only debts discharged in bankruptcy are covered (by the bankruptcy exclusion). If you settled a debt in January and filed bankruptcy later in the year, chances are you probably were insolvent in January but that’s a separate calculation that needs to be done.”
2. Debt canceled due to insolvency
Along with bankruptcy, this is one of the most common exclusions taxpayers will use to avoid paying taxes on canceled debt. Here’s how it works:
You make a list of the value of all your assets and a list of all the debts you owe (including debts that may not be dischargeable in bankruptcy, such as student loans, for example.) You are insolvent to the extent that your liabilities (debts) exceed your assets. Here are a couple of examples provided by Elliott:
Example 1: Your assets are worth $35,000 and your debts total $45,000, so you are insolvent to the tune of $10,000. You settle a debt with a creditor who agrees to forgive $8,500. You do not have to report any of that money as income on your tax return.
Example 2: Your assets are worth $35,000 and your debts still total $45,000, but the creditor writes off a $14,000 debt. You don’t have to report $10,000 of the income, but you will have to report $4,000 on your tax return.
You will still have to fill out Form 982 to demonstrate to the IRS why you aren’t including the amount listed on the 1099-C in your taxable income.
“Timing is everything,” says Purdy. “Take a look at your finances right before the debts were forgiven. Include student loans, debts to family members, everything that you owe everyone on the planet. List every single debt you have (on Form 982). On the other side you list the Fair Market Value of everything you have. For millions of people, their debts exceed the value of everything they have.”
All three advisors explained that taxpayers who erroneously paid taxes on forgiven debt may go back and amend prior year’s tax returns—for up to three years—and may actually get a refund.
Finally, if you’re worried about how your debt or other issues could be impacting your credit, you can check your credit each month using Credit.com’s free Credit Report Card. This completely free tool will break down your credit score into sections and give you a grade for each. You’ll see, for example, how your payment history, debt and other factors affect your score, and you’ll get recommendations for steps you may want to consider to address problems. In addition, you’ll also find credit offers from lenders who may be willing to offer you credit. Checking your own credit reports and scores does not affect your credit score in any way.
*Tax professionals may include Certified Public Accountants (CPAs), Enrolled Agents (EAs) or Tax Attorneys.
In my next post, I’ll discuss the exclusion for the cancellation of qualified principal residence indebtedness, which may be valuable if you lost your home to foreclosure or sold it in a short sale.
Have you received a 1099-C? We’d like to hear about your experience. What kinds of problems, or successes, did you encounter? Share your thoughts in the comments section below.