It is a sad but true fact that today’s economy has brought about a growing phenomenon related to debt and debt cancellation or forgiveness. People who in good conscience and good faith took on unsecured credit card debts and unsecured loans and credit lines have found themselves in the unfamiliar territory of having too little money to cover the payments that they once covered comfortably due to the ever increasing cost of groceries and fuel and, if we’re being honest, just about everything one pays for every day. Not surprisingly, every day when I turn on the TV I am bombarded by commercials urging people worn down by both ethical and unethical debt collectors to settle their debts for a portion of the balances due. This may be the only solution left to alleviate the stressful life of living day to day with too much month at the end of their money and it is important for this decision to be made with all of the facts out in the open so there are no surprises in the aftermath. So there are some pertinent, relevant facts that a person should know when making this decision.
According to the IRS, generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. You have no income from the canceled debt if it was intended as a gift to you. The IRS definition of a debt includes any indebtedness for which you are liable or which attaches to property you hold.
Debt that is cancelled by a creditor is generally considered taxable income for federal income tax purposes. I say generally because there is a matter of whether a person is solvent or insolvent at the time of the debt cancellation. What exactly does this mean? You are considered insolvent, when and to the extent that your liabilities (what you owe) exceed the fair market value of your assets (what you own) before the cancellation of your debt. This means that to be able to exclude some or all of your cancelled debt in this type of scenario you need to have good documentation as to whether you are insolvent and if so by how much when you are preparing your taxes or having your taxes prepared. The exclusion for insolvency is only up to the amount by which you are insolvent and there are additional adjustments related to certain tax attributes that also would have to be taken into consideration, including the basis of certain assets and certain losses and credits. These are certainly complicated tax concepts not for the faint of heart if you are attempting to prepare your own return but they are facts that should not be overlooked for anyone who is involved in a scenario that involves debt cancellation or forgiveness. If you have unsecured debt cancelled by banks, businesses, governments, etc. you will in all likelihood receive a 1099-C from the creditor that cancelled the debt.
The information in this article does not cover cancellation of all types of debt. There are different rules related to Bankruptcy, Mortgage Debt cancellation and each different form of debt cancellation. Additional detailed information is available at www.irs.gov.
This unfortunately is one of the more complicated issues that one might have to deal with on a tax return and the fact that the very need to seek cancellation of debt infers that a person or business is having financial difficulty makes it less likely that they will seek professional assistance with the preparation of their taxes due to the cost; however, if you are confused by this scenario and need assistance, if possible you should seek out reasonably priced professional help, or contact the IRS for assistance or for their recommendations for sources of assistance.
Times are difficult and good people are being caught financially between a rock and a hard place. This is a sad but true fact and I hope that this information is helpful if you are working hard to climb out from that dark place between those two rocks to enjoy the warmth of many sunny days ahead.
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