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Tax implications of cancellation of debt

Article by Ask Bill

You have opted for cancellations of debt as a way out of the increasing sums you owe your creditors. However, you do not know about the implications behind the cancellation of debt and whether it will be considered as an income, thus, making the forgiven sum taxable. Many questions are probably whirling around in your mind now and you are worried no end about possibly having to fork out thousands to the Inland Revenue Service.
Just to put your mind to rest, you may want to read on to learn more about the implications, especially the tax implications, behind this method of resolving your debt issues. First things first. If you are forgiven a sum more than $ 600 by a lender, the lender is required under the federal law to send you a ‘Form 1099C cancellation of Debt’ that you may need to fill in and submit to the IRS. This means the forgiven amount is a tax liability for you as it is considered an ‘income’. You may need to also fill in Form 982 to report the forgiven or cancelled amount and attach it with your tax return.
However, you do not need to be unduly worried about being taxed for the cancelled sum as there is an avenue for you to reduce or eliminate the cancellation of debt income (CODI). If you were insolvent right before the lender agreed to cancel part or the entire sum you owed, then you could eliminate the CODI. You are considered insolvent if all of your liabilities are higher than the fair-market value (FMV) of all of your assets. When we talk about liabilities, it takes into account the total debts you have including the cancelled or forgiven one and your nonrecourse debt that are less than the FMV of the property used as collateral for the debt. As for your assets, it includes everything you own that are of value such as the property used as collateral to obtain a loan, and also the exempt assets which you do not have access to such as interest in your pension plan or the value of your retirement account.
Here is n example of how to calculate your insolvency: Your liabilities, which include all your debts before any of it was cancelled or forgiven, amounted to $ 15,000. The FMV of all of your assets are $ 6,000. This means you are insolvent to the extent of $ 9,000 (you get this by deducting the $ 6,000 from your total liabilities of $ 15,000). Then one of your creditors cancelled a total $ 8,000 that you owed them. The creditor will send you a Form 1099C indicating that your debt of $ 8,000 has been cancelled. Since you are insolvent to the extent of $ 9,000 and the debt that was cancelled was $ 8,000 that is less than your insolvency, then you can exclude the whole $ 8,000 forgiven amount as CODI. Now, if your assets amounted to $ 10,000 and your liabilities amounted to $ 15,000, this means your insolvency is to the extent of $ 5,000. You may be taxed for CODI of $ 5,000 if your lender forgave you a total of $ 10,000 in debts (you deduct $ 5,000 of your insolvency from the $ 10,000 forgiven sum).

So, if you also owe money to the IRS, having some CODI may further increase the debts. Then perhaps, you may need to look into tax debt negotiation. You could get some professional help to assist you in dealing with the IRS for a way to settle the money you owethem. It is better that you try to settle your tax debts as soon as possible instead of letting it accumulate into an even larger unmanageable sum.

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