Canceled Debt: How To Know if You Are Insolvent

Canceled Debt: How To Know if You Are Insolvent

Debt cancelation is a problem that often arises at tax time and something every taxpayer should understand. Many people are relieved to be at the end of a long debt battle, only to find tax implications. As long as there is a short sale, foreclosure, or other forms of loan forgiveness, the value of the forgiven debts counts as income. These are not the only cases in which debt cancellation occurs, of course, but they are the ones we see. It is important to note that PPP loans are designed to be excluded from debt cancelation, which means an accepted PPP loan will not be counted as income on your tax return.

What is Form 1099-C - Debt Cancellation Form?

A Form 1099-C informs you that a creditor will "write off" the remaining portion of the debt you have not paid. Form 1099-C, Debt Cancellation, is filed by a creditor with the IRS when a settlement agreement is reached between you, the debtor, the creditor, or when the creditor determines that a debt will never be paid. If the debt is $600 or more, the creditor must file a Form 1099-C with you, the debtor, by January 31 and the IRS by February 28 of the fiscal year in which the debt was written off. 

Why did I receive a Form 1099-C: Debt Cancellation?

If you have defaulted in the past on a debt and you have agreed with a creditor to repay your debt or if the creditor has considered the debt to be in default and stopped trying to collect the debt, you may receive a Form 1099-C. The Internal Revenue definition of a compromise in a collection case is the forgiveness of debts based on an agreement between the creditor and the debtor to pay the debt for less than the full amount.


What should I do after receiving Form 1099-C: Debt Cancellation?

If you receive Form 1099-C from a creditor, you are required to report the value of the canceled debt as income to the IRS, even if you did not receive the money. (The value shown in box 2 of Form 1099-C is the amount to report as income.)

What debts are forgiven according to Form 1099-C?

The IRS recognizes five situations in which a forgiven debt should not be reported as income.

  • Bankruptcy: The debt has already been canceled through a bankruptcy proceeding. 

  • Gift: A gift is canceled when the debt has been treated as such. 

  • Indebtedness: Debt is due to certain losses of commercial real estate. 

  • Indebtedness: The debt is due to eligible farm expenses.

  • Insolvency: Total debt exceeds total assets at the time of debt cancellation or claims considered non-collectible. 

How do you know if you are insolvent?

You are considered insolvent if your total debt (liabilities) is greater than your total assets. For example, if your total liabilities are $ 10,000 and your total assets at that time are $ 6,000, you are insolvent for an amount of $ 4,000. To determine your assets' value, use fair market value rather than how much you paid for them or how much you think they are.

If you are insolvent, you will be required to explain this to the IRS in two ways.

  • By filing the IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness)

  • Attach a detailed letter to your tax return, explaining the debt and total assets calculation.

Helpful tips to avoid problems if you received a 1099-C.

  • Determine if taking on the debt is in your best interest or a smarter decision to pay off the debt in full. Failure to report additional income can be costly.

  • If you pay your debt for less than the full amount (paid in full), ask the creditor if they intend to send a Form 1099-C to the IRS.

  • See if the extra income you receive from debt cancellation will lead you to a higher tax bracket. For a 35% bracket taxpayer, a canceled debt of $ 5,000 can cost up to $ 1,750 in additional taxes.

  • The name of the lender may not be easily recognized on Form 1099-C. The lender may have sold the debt to a third-party collection agency, or the parent company's name may appear as the creditor.

  • You cannot pretend that you never received a Form 1099-C by email. 

Important: For people receiving public benefits and social housing, be sure to check if your discounted income will exclude you from the benefits you receive.



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