How to Claim the Insolvency Exemption for Canceled Debt Reported on Form 1099-C

It’s that time of year again. Millions of people who settled or had debts forgiven last year are receiving Form 1099-Cs for Cancelation of Debt Income and wondering if they will have to pay taxes on the forgiven amounts.

Many people are shocked to learn they might owe taxes on canceled debt balances. But it’s true. According to the IRS, forgiven debt translates to “income” because you enjoyed the goods and services that were originally purchased on credit but did not fully pay for those benefits. When a lender has to record a partial loss on those purchases, the IRS wants you to treat that formal loss as ordinary income.

Fortunately, a legitimate loophole is provided by the IRS in the form of the insolvency exclusion. “Insolvent” means the same thing as negative net worth, where you owe more in liabilities than the total fair market value of your assets. If you are insolvent at the time you reach a settlement with a creditor, then you can offset the 1099-C income up to the amount by which you were insolvent.

For example, let’s say you owned assets worth $50,000 at the time you had a $20,000 debt canceled. At the time, you also owed $80,000 in total debt, including the $20,000 that was forgiven. This means that your net worth was a negative $30,000. At the time the debt was canceled, you were therefore insolvent by $30,000 and would not have to pay taxes on any portion of the $20,000 debt that was canceled and reported via Form 1099-C.

In order to determine whether or not you qualify for this 1099-C exemption, you need a copy of IRS Publication 4681, which contains a worksheet for calculating insolvency. Publication 4681 provides detailed instructions for completing Form 982 — affectionately called “The Tax Form from Hell” due to its byzantine complexity. Form 982 is the document you include with your Federal Form 1040 to claim the insolvency exemption.

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Determining insolvency is pretty straightforward if you only have one 1099-C for the given tax year. However, if you settled multiple debts in the same year and have a bunch of 1099-C forms, that is when it can get tricky. Unfortunately, the IRS instructions say nothing about the correct method for determining insolvency across multiple settlements. Further, taxpayers’ eyes tend to glaze over when they reach Part II of Form 982 and try to figure out what the IRS means by “reduction of tax attributes.”

To help clarify the confusion and provide a useful tool that can handle multiple 1099-Cs, I’ve created an Insolvency Calculator that can potentially save you hours of frustrating effort trying to figure out what IRS Publication 4681 is actually saying. The cost is only $29, and the calculator is available for immediate download after purchase.

Here are a couple of tips to help you understand two key areas that often confuse taxpayers. First, it’s common for people to stumble when they see the line on the insolvency worksheet that asks you to list your “interest in a pension.” To most of us, “interest” means the annual rate of return we might earn on invested money. But that’s not what “interest” means in this context. It means your ownership stake in the pension or retirement account in question.

For example, let’s say you have an IRA account through your employer where they are matching your contributions, but you are not 100% vested in their matched funds until you’ve worked for the employer for a certain number of years. If your IRA balance is $20,000, but you’re only 50% vested, then that asset would be listed at $10,000 on the worksheet.

Another area that is confusing is how to calculate insolvency when the 1099-C is issued in one spouse’s name only, yet taxes are filed jointly. Must you include the entire household’s assets and liabilities in the calculation? The answer is no. The IRS allows you to split the calculation so that only the spouse named on the 1099-C has to demonstrate insolvency, based on the assets and debts held solely in that spouse’s name, and a pro-rated basis for assets and debts held jointly.

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These points and many others are discussed in the extensive User Manual that comes with the Excel based spreadsheet calculator. Multiple examples are included to illustrate different scenarios not directly discussed in the official instructions. ZipDebt’s IRS Form 982 Insolvency Calculator will save you time and money if you’re dealing with 1099-Cs from settled debts!

2 thoughts on “How to Claim the Insolvency Exemption for Canceled Debt Reported on Form 1099-C”

  1. I received a 1099-C for tax year 2021, I opened the card in 2008 and my last payment was December of 2013 so I always paid my bills but everything went wrong at one time, the card was closed as a bad debt on March of 2014, I just received a 1099-C stating I had an extra $10,532.50 in earnings this year from 2013 or 2014, I really can not believe this is allowed that after 7 years a bank can then all of a sudden hit someone with this. My main question is can they really do this after that many years and why did it take so long for them to come after me I have lived in the same home for 20 years. Is there anyway out of this as I really think this wrong. Thanks alot

    • A 1099 is not a debt collection process but a mandatory tax reporting process. I’m not sure exactly what triggered this in your case but late reporting is not that unusual. However, if you contact the IRS and report this as incorrect in this year and the creditor changes it, you will have to go back and probably file an amended return in the previous year. However, as you saw in my article, you may be able to claim the insolvency exemption and not have to pay tax on the recently reported debt.


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