John Roska: Canceled debt may have income-tax effect

John Roska: Canceled debt may have income-tax effect

Q: I settled a credit card debt by agreeing to pay a lump sum for less than the full amount I owe. The credit card company then said they'd issue a tax form for canceled debt, and that I'd have to report the unpaid debt as income on my taxes. Why? Is there any way around it?

A: They're talking about an IRS Form 1099-C. That's an official notice that a creditor gives you, and the IRS, that a debt has been canceled.

The tax code defines income broadly, as "all income from whatever source derived." In particular, the code also says that gross income includes "income from discharge of indebtedness."

So, while it doesn't feel like it, canceled debt is income. Just like earned income from employment, it must be reported as income when you file your taxes.

When more than $600 of debt is canceled, the creditor doing the canceling is supposed to report that fact to the IRS by issuing a 1099-C "Cancellation of debt" form.

That 1099-C tips off Uncle Sam, so he'll watch for that canceled debt to show up as income on your tax return. The IRS does the same thing with the W-2s they get reporting earned income — they match their information to the information you provide on your tax return.

As usual with the tax code, there are ways to reduce the tax hit, by reducing this income. For many people, that way is the "insolvency exception" to the general rule that canceled debt is income. If you're insolvent when the debt gets canceled, it's not income.

You just have to show your liabilities exceed your assets, at that particular point in time. That's pretty easy to do, especially for the low-income.

For example, most people who got an earned income tax credit could probably qualify for the insolvency exception. And a mortgage debt by itself can often exceed your total assets.

IRS Publication 4681 explains canceled debts, and has a simple one-page "Insolvency worksheet" you can use to list your liabilities and assets.

The amount that liabilities exceed assets, at the point in time when the debt was canceled, can be used to reduce or eliminate the income from canceled debt.

For example: A $10,000 debt settled for $6,000 results in a 1099-C for $4,000 of canceled debt. Total liabilities of $15,000 against $10,000 of total assets means you're insolvent by $5,000. That insolvency exceeds the canceled debt, reducing to $0 the income you'll have to report from that canceled debt.

If your assets were $12,000 in the above example, you'd be insolvent by $3,000. That amount could reduce the $5,000 income from the canceled debt to $2,000.

To claim the insolvency exception, you file Form 982 with your tax return. For simple canceled debt, like from credit cards, you just check Box 1b, and at Line 2 fill in the amount of canceled debt reduced by your insolvency.

John Roska is a lawyer with Land of Lincoln Legal Assistance Foundation. You can send your questions to The Law Q&A, 302 N. First St., Champaign, IL 61820. Questions may be edited for space.

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