How Proving Insolvency Could Save You Thousands of Dollars
If insolvency is proven on an IRS tax return, a taxpayer can save thousands of dollars because when a taxpayer is shown to be insolvent, canceled or forgiven credit card and loan debts do not have to be reported as taxable income. However, the reporting on the tax return must be done correctly as the IRS will not help without proper action on your part.
What is Insolvency?
If a taxpayer’s debt exceeds the total amount of his/her assets including cash, the value of real estate and personal property, and money held in retirement accounts, generally speaking, insolvency can be declared.
Under IRS guidelines, canceled debts must be reported as income. Credit card companies and lenders report canceled debts to the IRS and individual taxpayers by issuing a 1099-C. Once the taxpayer receives a 1099-C, he/she may file IRS Form 982 to show that all of the canceled debt is not taxable due to insolvency. There is an insolvency worksheet with instructions to help the taxpayer figure what portion of the canceled debts need to report as income. The 1099-C, along with the Form 982 and the insolvency worksheet, must be included with the taxpayer’s annual federal tax return. In most cases, the IRS will accept the information and figures provided on the insolvency worksheet as proof of insolvency without further documentation.
Allowed Exclusions from Gross Income
When a debt is canceled, forgiven or discharged by a third party, a taxpayer does not have to include such debt in gross income under the following conditions:
- The discharge occurs during the time the taxpayer is considered insolvent
- The discharge was part of a Chapter 11 bankruptcy plan approved by the court. A discharge that’s related to a Chapter 7 or Chapter 13 bankruptcy is automatically excluded from a taxpayer’s income.
- The discharge relates to qualified indebtedness from the taxpayer’s principal residence, and the discharge occurred before January 1, 2010. Qualified principal residence indebtedness relates to any mortgage taken out to purchase, build, or improve the main home. It also relates to money used to refinance, but only up to the dollar amount of the original mortgage prior to refinancing.
- The discharge relates to qualified indebtedness from real business property, other than taxpayer debts from a C corporation.
- The discharge is related to qualified indebtedness from farming income.