From the Archives: Insolvency and Canceled Debt: Make Sure You Can Prove It!

PROGRAMMING NOTE: Over the next two weeks, I’ll be re-posting popular blog posts from the past. New material will resume on Monday, January 4th.

This is perhaps the most-popular story I’ve ever written, about cancellation of debt and the “insolvency exclusion.”

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Originally published October 24, 2013

If you have a debt that gets canceled, the general rule is that you must report the canceled debt as income. For example, if the credit card company forgives $5,000 of credit card debt, you’ll need to report $5,000 of income on your tax return.

Many exceptions apply, such as debt cancellation relating to your primary residence (as in a foreclosure), bankruptcy or insolvency.

This blog post will focus on the insolvency exception.

What is Insolvency?

Insolvency is when the amount of your debt is greater than the amount of your assets, with assets being things such as cash in the bank, or the value of property you own.

Example: you owe $15,000 on a credit card and $100,000 on a mortgage, for a total of $115,000 of debt. Your home is worth $105,000, your car is worth $5,000 and you have $1,000 of cash in the bank, for a total of $111,000 of assets. You are insolvent by $4,000.

Insolvency and Canceled Debt

Canceled debt is not taxable to the extent you are insolvent. Using our example above, let’s say the credit card company cancels all $15,000 of credit card debt. You would report $11,000 of taxable income from this cancellation — $15,000 of canceled debt minus $4,000 insolvency.

Reporting Insolvency

Lenders will typically issue a Form 1099-C to you when they cancel a debt. In order to show that some or all of the canceled debt is not taxable due to insolvency, you’ll need to complete a Form 982 and mark the box that says “Discharge of indebtedness to the extent insolvent.”

And that’s it. Per the instructions to Form 982, no further explanation or attachments are needed.

In practice, though, the IRS often questions claims of insolvency by sending a notice to you several months after you’ve filed your tax return.

Insolvency Worksheet

When I’m helping someone with canceled debt, I have the person fill out the “insolvency worksheet,” which you can find on page 8 of IRS Publication 4681.

In my experience, submitting the insolvency worksheet to the IRS when they ask for proof of insolvency has been sufficient. I’ve never had them come back and ask for additional documentation beyond the worksheet, though they certainly could ask for additional documentation.

In order to further protect yourself, I would recommend keeping copies of bank statements and anything else that can prove the numbers shown on the worksheet.

Caveat: Beware of 401(k)s and IRAs

Money held in retirement accounts counts as an asset. You must include this money on the insolvency worksheet.

I have seen this derail attempts at claiming insolvency before. Clients have been sure, initially off the top of their head, that they were insolvent by thousands of dollars … except they hadn’t accounted for the thousands of dollars held in their 401(k). When they filled out the insolvency worksheet, they realized that they weren’t nearly as insolvent as they thought they were!