If I Am Insolvent in Paying My Debt, Do I Need to Report It on My Tax Return?

Most people take on debt with the best of intentions, but unexpected setbacks can push them off track. Lenders will call routinely when bills first stop getting paid, but after a while the calls will slow down or stop and the lender will charge off the debt. If a debt is canceled or forgiven, the U.S. Tax Code requires it to be included in income unless it meets one of the exceptions or exclusions, including insolvency.

Canceled Debt

In general, canceled debts must be included in income if you are personally liable for the debt or it is secured by your property. When the lender charges off the debt, it will issue Form 1099-C, Cancellation of Debt. In the case of an unsecured debt, this will likely be for the entire balance. If the debt was secured by an asset that has been repossessed or foreclosed, the 1099-C will report the deficiency balance -- the difference between what the item was sold for and what was owed. It is the borrower's responsibility to determine to what extent he must include the canceled debt as taxable income.

Exceptions and Exclusions

Canceled debts are not always required to be included in income. The code provides for exceptions and exclusions that limit the circumstances in which canceled debts are subject to income tax. Exceptions include canceled debts that are converted to gifts, certain student loans and debt that would have been deductible if it was paid. Exclusions include, among other things, debts discharged in bankruptcy or at a time the debtor was insolvent.

Extent of Insolvency

Insolvency is a financial condition in which you have a negative net worth. The U.S. Tax Code permits taxpayers to exclude canceled debts from income to the extent their liabilities exceed their assets. Worksheets are provided in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments, to help determine the amount of canceled debt that can be excluded from income due to insolvency.

Compliance

Lenders are required to issue Form 1099-C for canceled debts in excess of $600. Taxpayers, however, are require to report all canceled debts as "Other Income" on their Form 1040, Individual Income Tax Return, regardless of the amount, unless they meet one of the exceptions or exclusions. If a taxpayer wishes to exclude some or all of his canceled debt from income, he must include a completed Form 982, Reductions of Tax Attributes Due to Discharge of Indebtedness, with his income tax return. This form is used to report the amount of canceled debt not included in taxable income and the reason it has not been included. The canceled debt is always reported one way or the other. It is either included in other income on the Form 1040 or excluded as canceled debt on Form 982.