Newspapers and the Internet are full of articles regarding the recovering economy. However, taxpayers may need to "recover" by making agreements with credit card companies to lower the amount of debt owed. When this happens, the taxpayer usually receives a Form 1099-C at the end of the year. This form informs the Internal Revenue Service that a portion or all of a debt was forgiven.
The IRS views this forgiveness as income to the taxpayer. It is difficult to understand because the taxpayer did not receive the forgiven amount physically, but an agreement was made to reduce the amount of debt the taxpayer owed and therefore the reduction is no longer attached to a repayment. The taxpayer did receive property from the credit card company through purchases made before to the reduction of debt that they no longer have to pay for in full. Nevertheless, when the Form 1099-C is received the amount must be included as income to the taxpayer.
There are, however, certain circumstances that allow the taxpayer to exclude the amount as income.
If the taxpayer's 1099-C was from a foreclosure of his principal residence, the IRS allows for the debt to be excluded from the taxpayer's income.
However, there are conditions, as always, that must be met for this to occur.
The Qualified Principal Residence Debt was extended until Dec. 31.
The IRS allows for the exclusion of debt associated with a principal residence but is limited to $2 million of acquisition debt.
Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) must accompany the tax return.
If the debt canceled was not for taxpayers' principal residences, the debt may still be excluded if the taxpayers are able to show that they were insolvent immediately before the debt was canceled. The insolvency is determined by the taxpayer identifying the liabilities (bills) and assets (cash and property) owed and owned before the debt was canceled.
To simplify, let's look at the following example of insolvency outlined below:
Credit card debt
Income and real estate taxes due
Other loans and past-due bills
Cash and bank account balances
Fair market value vehicles
Fair market value real estate
Fair market value household items (furniture, etc.)
Investment accounts, IRAs, etc.
Cash value of life insurance
If the total of the liabilities is more than the total of the assets, insolvency exists.
Form 982 must be attached to the tax return and the canceled debt may be excluded in income. Remember to determine your financial position before the canceled debt.
If the debt canceled is not for a principal residence and the insolvency test shows that the assets are more than the liabilities, the amount of the canceled debt must be included on Line 21 of the tax return as income.
There are more ways to reduce the amount of the cancellation of debt and Publication 4681 goes into more detail regarding reducing the amount of the canceled debt on the tax return.
It would be beneficial to have a professional tax preparer, enrolled agent or CPA review the cancellation of debt to determine if exclusion is permissible.
Tracy Bunner is an enrolled agent and tax preparer with an office in Harrisville. She can be reached at 801-686-1995 or at firstname.lastname@example.org.