Persons who are able to negotiate debts and have them forgiven or reduced are often surprised to find that the IRS considers forgiveness of debt to be income, and therefore taxable. In this circumstance, where the amount cancelled is $600 or more, the creditor will send the debtor and the IRS a copy of form 1099-C. The taxpayer will then report this as “other income” on line 21 of Form 1040 when they file their federal income tax return.
But, not all cancelled debt is subject to taxation, though many taxpayers don’t know this fact. If you are “insolvent” according to IRS rules, you may legally avoid paying tax on the forgiven debt.
In order to take advantage of the insolvency exemption, however, taxpayers must fill out and attach IRS Form 982 along with the 1099-C to their federal income tax return. See also IRS publication number 4681, where you will find a worksheet to help calculate whether you were in fact insolvent when (in the tax year) when the debt was cancelled. More good news, for several years, you may be able to amend your return to claim insolvency for a prior year. Determining insolvency in this context can be complex and if the amounts involved are significant, finding an accountant is probably wise.
In a bankruptcy, cancelled debt is of course not taxable for that year, you are by definition insolvent for the purpose of paying income tax on discharged debt. Persons who get their debt eliminated by way of bankruptcy in Colorado generally do not have to worry about paying taxes on those amounts. Moreover, if you negotiate a debt down and then file bankruptcy in that year, you will also likely not have a tax problem. Sometimes, the creditor will write the debt off on their own, and send you the 1099. Seek professional advice in these circumstances.
It is estimated that only about 1 in 10 people who receive 1099s file the accompanying application for the insolvency exception. This is true even though roughly half of these taxpayers would qualify. In my practice I try very hard to inform clients of these issues, and the effect of filing bankruptcy or settling debt.
A Colorado bankruptcy lawyer should take a holistic approach to clients’ situations and debt. The goal is to get to the other side with as little debt as possible, and with a fresh start. I do attempt this with each and every client. I meet my clients, personally, and work with them for a “global” solution that makes sense. If you think I could help your family, please call (303) 670-4242 for a free consultation.