How to Figure Out If a Debt Written Off Is Taxable by the IRS

In challenging economic conditions, there are a lot of people who have debts that they cannot pay. As a result, a lot of these obligations are forgiven. Generally, when debt is forgiven, it is considered taxable income. However, there are some instances when debt is forgiven and is not taxed at all.

Difficulty:

Moderate

Instructions

1. Subtract all debt that is forgiven due to bankruptcy. All debt that is cancelled during Chapter 11 bankruptcy proceedings is not taxable. In addition, all debt cancelled during any bankruptcy proceeding is excluded, so long as the cancellation is either granted by the court or is the result of a plan approved by the court.

2. Determine if you are insolvent. If your liabilities exceed your total assets prior to the cancellation, you were insolvent at the time of cancellation. Assets for this purpose include everything of value you own, including assets that are encumbered by debt. Liabilities include all recourse debts and nonrecourse debts to the extent the debts equal the fair market values of the assets that secure the loans. All debts that were cancelled while you were insolvent are not included in taxable income.

3. Exclude all forgiven debt that was a gift to you. Transactions that are provided with a donative intent and without expectation of receiving any compensation are considered gifts, which are not taxable to the recipient. Instead, the gift is taxable to the donor.

4. Exclude forgiven debt related to the mortgage of your principal residence. Under the Mortgage Forgiveness Debt Relief Act of 2007, you can exclude up to $1 million of debt forgiven on your principal residence's mortgage for the 2007 through 2012 tax years. If you are married and filing jointly, you can exclude up to $2 million.

5. Report all remaining forgiven debt as income. All debt not excluded for the reasons listed here should be recorded on your personal return using a Form 1099-C. This should be included with your personal return when you file your taxes.

Tips & Warnings

• Warning and Disclaimer: If you have further questions about owed taxes, it is a good idea to consult with a certified public accountant (CPA) or licensed attorney, as they can best address your individual needs. If you have financial concerns that might make hiring a CPA or attorney difficult, there are alternative options, such as Low Income Taxpayer Clinics (LITCs) or the Taxpayer Advocate Service (TAS), an independent organization operating through the IRS that provides aid to taxpayers under duress. Contact the IRS to find an LITC or TAS representative near you. Every effort has been made to ensure this article's accuracy, but it is not intended to be legal advice.

References

• IRS.gov; Many Types of Free Help Available From the IRS; January 2011
• IRS.gov: Publication 4681 -- Canceled Debts, Foreclosures, Repossessions, and Abandonments
• IRS.gov: Publication 950 -- Introduction to Estate and Gift Taxes
• IRS.gov; Ten Facts for Mortgage Debt Forgiveness; March 2011
• IRS.gov: What If My Debt Is Forgiven?