If someone owes you money, and you figure — "hey, it's just not worth it to try collect on the debt", the general rule is you can 'write off' the bad debt and take it as a deduction.
The rule is that the IRS will claim that the amount you "wrote off" was income to someone else. When you wish to cancel debt over $600, chances are you will need to prepare a form 1099-C and send it to the person whose debt you are forgiving or cancelling. For the person who received the Form 1099-C Cancellation of Debt, they would have to report it in their gross income — making it taxable. So the act of debt forgiveness may in fact come back and harm the person with a tax bill from the IRS.
So, is debt forgiveness taxable?
The test comes from form 26 USC 108:
(a)(1) Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—
(A) The discharge occurs in a title 11 case,
(B) The discharge occurs when the taxpayer is insolvent,
(C) The indebtedness discharged is qualified farm indebtedness,
(D) In the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or
(E) The indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2014.
The most common type of cancellation of debt income we deal with
I was on the Stan Simpson show earlier this year to talk about type "(B)", the discharge of debt when a taxpayer is insolvent. This is very important — IT MAY NOT BE TAXED — depending on whether the taxpayer is "insolvent" or not. This happens a lot when people negotiate credit card debts.
The test for insolvency is as follows:
You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include: 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.
The IRS has a worksheet to determine insolvency at the end of Publication 4681. If you need assistance with a tax issue, contact us for a free consultation.
