Cancellation of Debt
By Michael Aston, E.A.
Alhambra Tax Center
If you owed money on a credit card or some other debt that was forgiven -- the amount forgiven may become taxable.
The most common type of debt forgiveness is credit cards. The credit card company forgives you from paying off all, or a portion, of a credit card debt. Another type of loan cancellation is a short-sale. You owe more money on your home, than what your home is worth. And any unpaid mortgage balance is cancelled through the short-sale.
If any portion of a debt is cancelled, you’ll most likely get an IRS Form 1099-C.
IRS Form 1099-C is a Cancellation of Debt.
This form is reported to the IRS. Which means, the IRS will be looking for the amount as taxable income on your tax return. But not everybody who gets a 1099-C will have to report the amount as income. And it all depends if you’re ‘solvent,’ or ‘insolvent.’
Solvent is when the Fair Market Value (FMV) of all your assets exceeds the amount of money you owe (liabilities). If you get a 1099-C and you’re solvent – all of the amount is taxable income.
Insolvent is the opposite. Your liabilities are greater than your assets. If you’re insolvent -- you do not pay taxes on the debt forgiveness up to the amount that you are insolvent.
Here’s an example of Solvent:
You receive a 1099-C for $5,000 dollars. The FMV of all your assets is $15,000 and your liabilities are $8,000. You have $7,000 dollars in equity. The full amount of the 1099-C is taxable. (Report $5,000 of income on your tax return.)
Here’s an example of Insolvency:
You receive a 1099-C for $5,000 dollars. The FMV of all your assets is $5,000 and your liabilities are $12,000. None of the 1099-C amount is taxable.
Here’s another example of Insolvency:
You receive a 1099-C for $5,000 dollars. The FMV of all your assets is $5,000 and your liabilities are $8,000, $2,000 of the 1099-C amount is taxable.
There are other scenarios that will not be covered in this articles on how an insolvent person may have to pay taxes and can be found in IRS publication 4681. But these situations are rare.
If you have any questions please contact the IRS or any tax professional.