When one borrows money, loan proceeds are not taxable. That’s because the loan has to be paid back. Seen that way, proceeds do not increase one’s wealth because of the payback obligation.
When one does not pay a loan, something different happens than originally contemplated. The borrower suddenly acquires “wealth”, since he no longer is going to pay back. And the Internal Revenue Code sees that as something very appropriate to tax. It is income. It is “phantom” income, to be sure, but income nonetheless. Therefore, a forgiven debt becomes fair game for the taxman.
In the real world, this has very real consequences. Suppose you owe more on your house than it is worth (your loan is “upside down”) and you sell “short”. The amount forgiven (the note balance less what the sale provided to pay off the note) is income. Most who sell short do so because their finances no longer support a mortgage payment, and the sudden federal and state tax bill adds insult to injury.
Cancelled credit card debt, repossessed cars, business debt…any of those things can also lead to cancellation of debt income.
The creditor sends you a form 1099-C reflecting the forgiven amount, and from there, it is supposed to go right on your return.
The Mortgage Debt Relief Act of 2007 generally allowed taxpayers to exclude income from the discharge of debt on their principal residence, but only applied to debt forgiven in calendar years 2007 through 2014. That is no longer available.
The insolvency exception….
There is an important exception to this unsavory rule. If one is “insolvent” then the cancelled debt is not included in income. That is huge.
How do you know if you are “insolvent”? Simple. You are insolvent when your total debts exceed the total fair market value of all of your assets. Assets include everything you own, e.g., your car, house, condominium, furniture, life insurance policies, stocks, other investments, or your pension and other retirement accounts.
The liability section is calculated immediately before the forgiveness, so it includes the forgiven debt itself, and any other debts you owe.
Remember the old formula: Assets-Liabilities=Net Worth.
If that number results in a negative number, voila! You are insolvent. This information is provided to the IRS on Form 982, which is attached to your federal income tax return. Publication 4681 has a worksheet to help you figure if you are insolvent.
What if you got a 1099-C for 2014, did not know about the insolvency exception, and you already filed? You can file an amended return. If you timely filed your tax return, you can still make the election to exclude the “cancellation of debt income” by filing an amended return within 6 months of the due date of the return (excluding extensions). Write “Filed pursuant to section 301.9100-2” on the amended return and file it at the same place you filed the original return. Of course, this will likely also require you to file an amended state tax return…in this case, a very good deal.