IRS Rules for Settling Debt in New York State
When you settle a debt, you may pay the debt in full, or the creditor may cancel a portion of the debt in exchange for a partial payment. However, the Internal Revenue Service sometimes imposes a tax on canceled debts. The rules governing the taxation of such debts are the same for taxpayers from all states, including New York.
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Canceled Debts
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If a lender cancels a debt for which you were personally liable, the IRS typically requires you to report the amount of the canceled debt as income. If the amount of the canceled debt exceeds $600, the lender will send you a copy of Form 1099-C, which you can use to report the amount of the debt on your income tax return. However, you must pay tax on the canceled debt even if you don't receive this form.
Exceptions
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The IRS doesn't require you to pay taxes on any debt canceled during bankruptcy proceedings, nor does it require you to pay tax if the cancellation was a gift. The IRS also exempts you from paying taxes on the cancellation of student loans that occur as part of an approved program that allows students to work in return for the cancellation of their loans. However, the entity providing the program must be the federal government, state government, local government, a tax-exempt corporation or an educational institution.
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Insolvency
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The IRS may allow you to exclude taxable canceled debts from your income if you were insolvent immediately before the cancellation. The IRS considers you insolvent if your total liabilities exceed the fair market value of your assets. Countable assets include all of your property and interests, even if they aren't available for garnishment by judgment creditors. Your total liabilities include all of your debts, whether or not you are personally liable for them.
New York Considerations
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Because New York requires you to report your federal adjusted gross income on your New York tax return, you will also pay New York state taxes on the amount of your canceled debt if the IRS required you to pay federal taxes on it. However, canceled debts that weren't taxable at the federal level won't be subject to New York income tax either.
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