How to File Insolvency With the IRS

Whenever a financial institution cancels all or some of the debt you owe, you are issued a 1099-C, reflecting the amount that was settled or cancelled. A financial institution can also issue a 1099-C if there is a repossession of collateral such as a car or a home foreclosure in which the repossessed property does not cover the entire debt owed. You are issued a 1099-C for the balance. You may also be issued a 1099-C if the creditor has exhausted all attempts to collect the debt and has deemed it irredeemable.The IRS considers any amount reported on a 1099-C as taxable income unless you can prove insolvency at the time of cancellation.

Difficulty: Moderately Challenging

Instructions

1. Compile your 1099-Cs if you received more than one and add up the entire amount. For example, if you owe $10,000 on a credit card and you settle the debt for $5,000, the credit card company would write off $5,000 and report this to the IRS on a 1099-C. The IRS would technically treat the $5,000 as income. Creditors are required to report debt cancellation or settlement that is $600 or higher to the IRS.

2. Make a list of and account for your assets. Your assets would include all the valuable things you own that could be sold for cash. These include your home, car, jewelry, art work and other valuables. When making this list you need to determine their fair market value. It will help if you have documentation that shows current market value and, for things like art work, current appraisals.

3. Make a list of and account for your liabilities. Your liabilities will include any debts, including debts owed on some of the articles listed as part of your assets.

4. Create a financial statement and determine your insolvency. Using the two sets of numbers, create a financial statement, which is a table of your assets compared with your liabilities. If the total amount of your liabilities in dollars exceeds the fair market value of your assets at the time you received any form of debt cancellation or settlement, you are deemed by the IRS as insolvent. If you are insolvent, you are not required to report the amount on the 1099-C as income. However it is advisable to file for insolvency because your creditors would have sent copies of your 1099-Cs to the IRS.

5. File for insolvency along with your tax return. You can do so by filing IRS Form 982, "Reduction of Tax Attributes Due to Discharge of Indebtedness." You may also send the IRS a detailed letter with a financial statement showing your insolvency. Bear in mind that the IRS forgives treating canceled debt as income only to the extent of insolvency. For example, if the total value of your assets is $80,000 and your total debt it $100,000, you are insolvent by $20,000 and only that amount of canceled debt can be excused from being taxed. So if you receive a1099-C reflecting a debt cancellation of $25,000, $5,000 will be taxable.

Tips & Warnings

• If you file for insolvency, make sure you keep records to properly document and prove the fair market value of your assets as well as the value of your liabilities. Congress in 2007 approved a provision that allows the IRS to excuse debt canceled in a home foreclosure (for a primary residence) between 2007 and 2012 from being taxed. See the first link in Resources below for more details.
• In some cases like the one described in step 5 above, it may make more sense to work out a long-term affordable payment plan with your creditor instead of settling the debt. That way you don't end up paying more to the IRS in taxes.

Resources

• More from the IRS on Debt Cancellation and Insolvency
• Fillable IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness

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