Injury, Sure, But Hold the Insult. Facing a Tax Bill on Cancelled Debt? There is a Way Out...

Many folks have lost a job or watched their income plummet during this financial crisis, and that’s meant more people defaulting on their credit-card or other loans. So here you are, in early 2009, having defaulted on your credit card debt and ruined your credit — and you’re staring at a1099-C. After losing so much already, you face the added difficulty of owing taxes on cancellation-of-debt income. Talk about being in the pit of despair. Where are you going to get the money to pay these taxes when you have absolutely nothing left to tap?

Hold on a second!
You might be able to avoid those extra taxes altogether, said Bill Fleming, a managing director in PricewaterhouseCoopers’ Private Company Services Practice. The rules and computations are complicated, so you may need some help. But the great news is this method does not require you to file bankruptcy.

Insolvency 101
This technique is as old as the hills. There’s even a form to use to let IRS know how much canceled debt doesn’t need to be taxed because you are insolvent. See Form 982 on the IRS site (PDF). Use Line 1b for credit card debt. You can see there are other lines for business real estate and your personal residence. Unfortunately, despite four pages of instructions that come with this form, IRS does not provide a worksheet to help you calculate just how insolvent you are.

Why is that important? You can only exclude canceled debt from your income up to the amount that you are insolvent before the debt was canceled, Fleming said. So let’s say you get a 1099-C that shows the lender wrote off $50,000 of credit card debt on June 15. You will need to create your own worksheet summarizing your assets and debt, including this $50,000 debt. For this calculation, remember to include the balances in your IRAs and retirement accounts. (According to Fleming, in a bankruptcy, you wouldn’t need to takes these funds into account.)

To really simplify the explanation, the amount of your insolvency on that day is the difference between your total debt and your assets. So, suppose that on June 15 your total debt, including mortgages and unpaid taxes, add up to $450,000. Let’s say that on that day, the fair market value of your home, savings and retirement accounts, the cash value of your insurance policies, used cars, furniture and personal property all add up to $405,000.

That means, on the date shown on that 1099-C, you were only insolvent up to $45,000 ($450,000 – $405,000). That means you will have to pay tax on $5,000 of the canceled debt.

You’re going to want to do this worksheet on the date that each separate debt was canceled, Fleming said. That’s a twist many people overlook when they do insolvency calculations.

After all, when the debts get canceled on different dates, you will have a different balance as each successive debt is canceled. You will also have a different balance of assets and money in the bank on each date.

For instance, suppose you have another $25,000 credit card debt canceled on Oct. 1. By this time, the value of your retirement portfolio has dropped dramatically (down $30,000), as did the value of your home (down $100,000).

Using the same debts as before, less the $50,000 that was canceled in June, your new balance of debts will be $400,000.

That is, your new asset balance with those declines in fair market value will be $275,000 ($405,000 less retirement-plan drop of $30,000 and home-value decline of $100,000). On Oct. 1 you are insolvent to the tune of $125,000 ($400,000 – $275,000). As a result, on that day the entire $25,000 canceled debt is excluded from income. It was worth doing a second calculation, right?

Let’s face it, if you’re at the point where the credit card companies and other lenders are writing your debt off as uncollectible, you’re probably insolvent, even without filing for bankruptcy. It’s just a matter of proving it to IRS.

A price for insolvency
Naturally, to take this cheaper, easier, non-bankruptcy option to get out of tax, there’s a price. You must have proof of your debt and asset balances at each date. Fleming said that the higher the amount of canceled debt you exclude from income, the more careful you want to be with your back-up documents. In some instances, it may be worth the price to pay for appraisals showing the value of key assets on the specific dates.

You can get free documentation of some asset values on the Internet. For instance, MarketWatch has a tool to help you get stock values on specific dates. You can get vehicle values at Kelly Blue Book and You may be able to find the value of other personal assets on or even use TurboTax’s ItsDeductible tool, which is now free. Keep copies of loan balances on those dates. Get them from the lenders and put a copy of the documents in your tax file. You don’t need to send any of this to IRS. But the larger the excluded balances, the higher your chance of getting audited.

Yet another price
Look back at Form 982. Do you see Part II where it says “Reduction of Tax Attributes”? This is where you’re going to take the amount of the excluded debt and reduce a variety of tax benefits you’ve been carrying over for a while. You’ll lose net operating loss carryovers, foreign tax credits, capital loss carryovers and more.

Remember, you still have to report the income from that 1099-C on your tax return. But you will also get to remove the income by following the instructions on Form 982. Can’t do it alone? Get help!

Start with the guidance on the IRS site, which has links to resources to help you with insolvency and the special relief rules for residential real

Folks who want to avoid a lot of tax on this phantom income, be darn sure you get these computations right. Consider investing a little money in a tax professional with experience dealing with insolvency. This is too important to trust to someone who’s learning on your dime and your time. You don’t want to find out two years from now that you did it all wrong and suddenly have to pay taxes you didn’t expect.

Source: Eva Rosenberg of MarketWatch

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