I remember the first phone call that I received about insolvency exceptions. A taxpayer called to ask me how to protect his daughter who had just been foreclosed upon – she was told to expect a tax bill as a result of the foreclosure. I remember thinking, “Wow, foreclosure? But how?” These were not folks who were living hand to mouth. They weren’t speculators. They were well-educated and knowledgeable about business. It didn’t make sense… until other taxpayers reached out with similar stories. The pattern would become disturbingly familiar over the next few years: it was the beginning of housing free fall, banking failures and eventually, the recession.
I haven’t been kind about some of the “fixes” that have been put in place to try and right the ship that is our economy. I think far too many of the efforts have been reactionary and short-sighted (new homebuyer tax credits, anyone?) rather than prospective and forward-thinking. But then, hey, maybe that’s just me.
That said, one of the areas where Congress has been reasonably thoughtful about economic woes has been the impact of debt cancellation on taxpayers. The old rules were pretty oppressive. You could easily find yourself in a situation where you’ve lost your home and your savings and yet faced a huge tax bill. This is because debt cancellation was considered income to taxpayers. It still is – but there are some exceptions.
One relatively new exception can be found in the Mortgage Debt Relief Act of 2007. Under the Act, taxpayers can generally exclude from income the amount of a discharge of debt on a main home. So, the amount of mortgage which was discharged after a foreclosure would not be included as taxable income. Similarly, debt reduced through mortgage restructuring qualifies for the relief. That gives homeowners who were facing potentially large tax bills as a result of losing (or almost losing) their homes some breathing room.
Another potential avenue to for relief: debts discharged through bankruptcy are not considered taxable income.
But foreclosures and bankruptcies are pretty dramatic. A less drastic option, insolvency, is another exception to the cancellation of debt income rules. It’s also a wee bit confusing and sometimes, frustrating to taxpayers. Here’s my best advice: try not to think about your definition of insolvency or your bank’s definition of insolvency or Suze Orman’s definition of insolvency. For tax purposes, you only want to think about the IRS’ definition of insolvency. And here it is:
For purposes of relief under the cancellation of debt income rules, you are insolvent if the total of all of your liabilities was more than the fair market value of all of your assets immediately before the cancellation. For purposes of this calculation, your assets include the value of everything you own. Liabilities include the entire amount of recourse debts (debts that you are personally responsible for but not guaranteed with specific collateral, like your credit cards), the amount of nonrecourse debt (secured debt, like a mortgage) that is not greater than fair market value of the security, and the amount of nonrecourse debt that is greater than the security to the extent nonrecourse debt in excess of the FMV of the property subject to the debt is forgiven.
And here’s how it works: if, under the tax laws, you were insolvent immediately before the cancellation of debt, you would not include that canceled debt in income. Generally, your canceled debt would be reported to you on a form 1099-C. Of course, the lending institution or bank which issued you the form 1099-C doesn’t know that you qualify for an exception so you’re going to have to let the IRS know why you’re not including the amount of that 1099-C in income for tax purposes. You do this by completing a federal form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) (downloads as a pdf) and attaching it to your federal income tax return.
The IRS has a handy dandy publication to assist you with the insolvency calculations. Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals) is a great resource but, for some odd reason, has been unavailable on the IRS website (when you click on the pdf version, you get this). I assume they’re updating it. However, I happen to have a copy of the insolvency worksheet from page 6 of the old Pub (downloads as a pdf here) but please keep in mind that it’s an older version. I’ll update it if when the IRS uploads a current version of the Pub.
When I work on my insolvency worksheet it says to take line 37 and subtract line 15.. That puts me in the negative b/c my debt is more than my asset does that consider me for insolvency?
Amy, only to the extent that you have canceled debt and otherwise qualify. Just read the instructions carefully.
Kelly,
I have a cancelled debt and I am trying file for insolvency. I did the worksheet and completed Part I of Form 982. However I am a bit confused on how to complete Part II.
Hi,
While I am preparing insolvency worksheet, I got stuck putting my 401K fund. Should I put before tax value or after tax?
I am confused on part II as well. Please help me. Thanks,
Hi,
Thank you for this blog. The info here is so much easier to comprehend than the IRS jargon.
My issue is with multiple settlements of credit card debts and I have a few additional questions about insolvency:
1) When I file the 982 form showing insolvency, I assume I also have to file a 1040A. Is this the case, even though I did not work in 2010 and have no other income information to submit to the IRS?
2) Will my girlfriend be able to file as head of household and claim me as a dependent while I file the 982 and the 1040A showing I’m insolvent?
3) I’ve read on other sites that I must submit a 983 for each debt “forgiven”. I had 5 credit card settlements altogether, must I submit a form for each or can I calculate the totals. To that end, say that my liabilities are 10k, assets 2k so insolvency is 8k; do I use each individual forgiven amount in relation to the insolvency number or the total of the debts forgiven? If looking at the debts individually in relation to the insolvency amount, it seems easy to classify as insolvent whereas adding the total debts could top the insolvency amount. To try to clarify using the above numbers say the 5 forgiven debts are each 2k, the total would be 10k of debts forgiven and I’d owe income tax on the difference of the total and the insolvency amount. If I look at each debt individually, they would all qualify for discharge because they would be well under the amount of insolvency. (I hope that’s not too confusing).
Thank you for any additional help you can offer!
With great appreciation,
JG
In the Insolvency Worksheet, how do we figure the Retirement and Pension assets?
Not sure what to do, I was planning to file Bankrupt but was told about Insolvency and that it may be better for my situation. I was forclosed on a couple of years back but I had a second on the house that i used for a pool. I believe the first mortgage is gone because the house is now oned by a new homeowner but the second is still checking my credit monthly. I have not had any contact with them in more than a year. Any advice.
Seems more or less straightforward, but 2 questions relating to insolvency filing. Received 1099-A from lender on my primary residence (Freddie Mac) reflecting principal bal of 194k and FMV of 160k at the time the house was foreclosed (FMV reflects the actual price paid by the buyer to the lien holder at a sale on the courthouse steps). As I’ve not received a 1099-C, I assume I should show the difference between the two (34k) as the mortgage amount on the insolvecy worksheet???? Or do I show the 194k amt from the 1099-A box #2 labeled “Balance of principal outstanding” ??? Next, I received a 1099-C from HELOC bank dated right at year end, also received two 1099-Cs from credit card companies dated about 60 days prior (end of October). Do I do separate worksheets for each based on the 60 day time difference or can I consolidate in some way?? Thanks in advance.
I too received a 1099-c for a short sale in 2012. I’m trying to determine insolvency. My situation is:
I currently receive a monthly annuity (I retired from the Post Office about 4 years ago), do I have to include these payments on the form 982 worksheet (Interest in a pension plan, or anywhere else), and if so, how would I compute this?
This may determine whether or not I qualify for insolvency.
Thank you!
My son and I both get SSI. I do not work. I get child support. I have not filed income tax for years. I have only a checking account and nothing that gets interest. I rent an apartment. I do not have anything of value except a 2008 car. I got two 1099-c forms because I could not pay the credits cards off. What do I do? Am I suppose to file a tax return?