Cancelled Debt can be excluded from income using form 982

Ten Forty + Quality Tax Preparation & Financial Services 281-397-7777 Fax 281-397-7443 Tax Tip Cancelled Debt using form 982 to avoid paying Tax Cancellation of Debt— Insolvency Taxpayers with cancelled debt can often exclude the cancellation of debt income to the extent they were in- solvent immediately before the cancellation. If a cancelled debt is excluded from income, it is nontaxable. Cancellation of Debt Cancellation of debt (COD) is settlement of a debt for less than the amount owed. A debt may be cancelled by a lender voluntarily or through bankruptcy or other le- gal proceedings and may result in ordinary income, in- come from the sale of assets, or both. Cancelled Debt Situation Tax Treatment Debt owed by a taxpayer is cancelled or forgiven. Amount cancelled or forgiven is generally taxable as ordinary income from cancellation of debt. Property that is security for a debt is taken by the The transaction is treated as a sale of the property, which may result in a gain or lender in full or partial satisfaction of that debt. loss. Property that is security for a debt is taken by the Excess of cancelled debt over FMV is ordinary income from cancellation of debt, lender, and lender cancels recourse debt in excess of in addition to any gain or loss from the sale. FMV of property taken. Cancelled debt is intended as gift. Amount cancelled is not income. Gift tax may apply. Form 1099-C, Cancellation of Debt If a lender cancels or forgives a debt of $600 or more, it must provide the borrower with Form 1099-C, showing the amount of cancelled debt to be reported as income. Generally, individual taxpayers must include all can- celled amounts, even if less than $600, as Other Income on line 21, Form 1040. Examples of COD Income Non business credit card debt cancellation. If non- business credit card debt is cancelled, the taxpayer may be able to exclude the cancelled debt from income up to the extent he or she is insolvent. Personal vehicle repossession. If the taxpayer had a personal vehicle repossessed during the year, the trans- action is treated as a sale, and gain or loss on the repossession must be computed. If the lender also cancels all or part of the remaining debt, the taxpayer may be able to exclude the cancelled debt from income to the extent he or she is insolvent. Taxpayer Insolvency A taxpayer is insolvent to the extent that the total of all their liabilities exceeds the fair market value (FMV) of all their assets immediately before the cancellation of debt. For purposes of determining insolvency, assets include the value of everything the taxpayer owns (including as- sets that serve as collateral for debt and exempt assets which are beyond the reach of creditors, such as the value of a retirement account). Liabilities include the following items: • The entire amount of recourse debts, • The amount of non recourse debt that is not in excess of the FMV of the property that is security for the debt, and • The amount of non recourse debt in excess of the FMV of the property subject to the non recourse debt to the extent non recourse debt in excess of the FMV of the property subject to the debt is forgiven. Example #1 – Amount of Insolvency More Than Cancelled Debt Jill was released from her obligation to pay her personal credit card debt in the amount of $5,000. Jill received a Form 1099-C from her credit card lender showing can- celled debt of $5,000. Jill uses the insolvency worksheet to determine that her total liabilities immediately before the cancellation were $15,000 and the FMV of her total assets immediately before the cancellation were $7,000, which means that immediately before the cancellation, Jill was in- solvent to the extent of $8,000 ($15,000 total liabilities mi- nus $7,000 FMV of her total assets). Because the amount by which Jill was insolvent immediately before the cancellation was more than the amount of her debt cancelled, Jill can exclude the entire $5,000 cancelled debt from income. Example #2 – Amount of Insolvency Less Than Cancelled Debt Assume the same facts as Example #1, except that Jill’s total liabilities immediately before the cancellation were $10,000 and the FMV of her total assets immediately before cancellation were $7,000. In this case, Jill is insolvent to the extent of $3,000 ($10,000 total liabilities minus $7,000 FMV of her total assets) immediately before the cancellation. Because the amount of the cancelled debt was more than the amount by which Jill was insolvent immediately before the cancellation, Jill can exclude only $3,000 of the $5,000 cancelled debt from income under the insolvency exception. Jill must include $2,000 of cancelled debt as an addition to her income, unless another exclusion applies. Form 982 Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, is used to exclude cancelled debt from in- come due to insolvency and also to indicate a reduction in tax attributes for certain assets, if required. Reduction of Tax Attributes If cancelled debt is excluded from income, the taxpay- er must reduce certain tax attributes by the amount ex- cluded. Tax attributes include the basis of certain assets, losses, and credits. By reducing the tax attributes, the tax on the cancelled debt is partially postponed instead of being entirely forgiven.This prevents an excessive tax benefit from the debt cancellation. Insolvency Work Sheet All amounts listed should be immediately before the debt cancellation. Liabilities 1) Credit card debt............................................................. 1)________ 2) Mortgages (and home equity loans).............................. 2)_____________ 3) Car and other vehicle loans........................................... 3)_______________ 4) Medical bills owed ........................................................ 4)______________ 5) Student loans ................................................................ 5)_____________ 6) Accrued or past-due bills owed .................................... 6)___________ 7) Federal or state income taxes due ................................ 7)____________ Judgments..................................................................... 8)________ 9) Business debts .............................................................. 9)_________ 10) Other loans and past-due bills..................................... 10)____________________ 11) Total liabilities. Add lines 1 through 10......................... 11) _______________ Assets 12) Cash and bank account balances ............................... 12)__________________ 13) FMV real estate ........................................................... 13)______________ 14) FMV vehicles............................................................... 14)___________________ 15) FMV household items (computers, tools, jewelry, clothing, appliances, furniture, etc.) ............................................................................. 15)____________ 16) Retirement accounts, IRAs, etc. .................................. 16_____________) 17) Cash value of life insurance ........................................ 17)____________ 18) Stocks and bonds ........................................................ 18)________________ 19) Interest in education account ..................................... 19)_____________ 20) Investments in collectibles.......................................... 20)_____________ 21) Security deposits ........................................................ 21)______________ 22) Interests in partnerships ............................................. 22)_________________ 23) Value of investment in business .................................. 23)______________ 24) Other assets ................................................................ 24)____________ 25) Total assets. Add lines 12 through 24........................... 25)_____________ 26) Amount of insolvency. Subtract line 25 from 11......................................................................... 26) ____________ If zero or less, taxpayer is not insolvent. If over zero, the amount is the extent to which the taxpayer is insolvent. Tax season is here. Go to www.tenfortyplus.com and complete your online organizer (under forms and documents). Make your appointment using our online appointment system. Call 281-397-7777 and get a user id with password set up so you Regards, Joseph C Becker EA www.tenfortyplus.com 281-397-7777, Fax 281-397-7443 joeb@tenfortyplus.com Contact Us There are many events that occur during the year that can affect your tax situation. Preparation of your tax return involves summarizing transactions and events that occurred during the prior year. In most situations, treatment is firmly established at the time the transaction occurs. However, negative tax effects can be avoided by proper planning. Please contact us in advance if you have questions about the tax effects of a transaction or event, including the following: • Pension or IRA distributions. • Retirement. • Significant change in income or • Notice from IRS or other deductions. Revenue department. • Job change. • Divorce or separation. • Marriage. • Self-employment. • Attainment of age 59½ or 70½. • Charitable contributions • Sale/purchase of a business property in excess of $5,000 • Sale or purchase of a residence or other real estate.