Insolvency and the IRS

When a financial institution cancels all or some of the debt you owe, they will issue a 1099-C, which shows the amount that was cancelled. If they repossess your car or home and the value of the property does not cover the debt still owed, they will issue you a 1099-C for the balance. You can also receive a 1099-C if your creditor has been unable to collect the debt you owe to them. The IRS considers any of these situations as taxable unless you can prove insolvency at the time of cancellation.

You might be able to exclude the cancelled debt from your income using the insolvency exclusion. Taxpayers are considered insolvent when their total liabilities exceed their total assets (ie, they owe more than they own). Normally, a taxpayer is not required to include cancelled debt in income to the extent that the taxpayer is insolvent. The cancelled debt could also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If the discharged debt was for your mortgage on your primary residence, you will most likely be able to exclude the proceeds using the Section 121 exclusion. There are many other situations that will allow you to discharge the debt.

If you receive a 1099-C for any type of cancelled debt, make an appointment with your tax preparer to discuss what you need to do to prove to the IRS that you are eligible to exclude all or part of the discharged debt from your income. Your preparer will probably ask you to bring a list of your assets (cars, homes, property, stocks, etc.) and how much you still owe to any financial institutions (mortgage, car loan, credit card balances, etc). They can work with you to minimize the tax consequences of debt forgiveness.  

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