My friend Ned had a lot going on for him. He was one of the top employees at the corporation he was working for and he was on the verge of a promotion that would increase his income by a wide margin. He was expecting a life changing opportunity and started upgrading his life by spending above his pay grade. Little did he know that the recession was going to hit and that it would hit him big time. He ended up losing his job, his home and his car as the company had to shut down. When it was time to file his income tax returns, he knew he would have to learn more about cancellation of debt income so that he could avoid having to pay taxes on properties that were no longer his.

Ned knew that there are types of ‘phantom’ income that may incur a tax even if he does not get any physical cash. For example, he could owe the bank $100,000 but the bank forgives that amount. The amount would be considered as a cancellation of debt income because even though he would not see a cent of that money, Uncle Sam would perceive it as if the bank handed over to Ned $100,000. So Ned combed through every single one of his financial activities including his loans, mortgages and big purchases to ensure that he could get rid of anything that would make him liable for tax even after he had to let go of some items like his yacht. After all, he now has no income so how could anyone even consider him liable for income tax.

One of Ned’s brothers once loaned him $5,000 when he started his first job. The money was used for the first few months that Ned had to venture out on his own like to pay the deposit for his rent. Of course, having borrowed money from his brother, Ned did not see the urgency to quickly repay the debt even after a few years of working up until he reached executive level at his office. Now that he is jobless, his brother decided to cancel that debt. Ned knew that a debt canceled by a private lender like his brother would be considered as a gift so he would not be liable for debt cancellation tax. It would be a win-win situation because his brother too would not be liable for tax for that $5,000 because it would fall under the gift tax annual exclusion.

Ned was considering filing for bankruptcy because he had more debts than the means to pay them. So he did his research to see if he would still be liable for tax if he was in bankruptcy or if he would qualify for a tax debt help. He was ecstatic to find out that if his debts were discharged when he was in bankruptcy, the cancellation would not be considered as income to him. Therefore he would not be liable for tax. However, there are some complicated rules and he would have to fill Form 982 in order to declare his bankruptcy and to reduce certain tax attributes such as the basis of his property. The next best thing would be to determine if his liabilities exceed his assets by more than the amount of the discharged debt so that he would not be considered as taxable either.

Even if he would not be liable for tax, Ned would probably still be required to file in his tax returns especially Forms 1099 to declare the forgiven debts. He would still need to liaise with his creditors or lenders who had forgiven his debts to receive his Form 1099-C. Of course, if he was in disagreement with the amount shown in the forms he could fill out Form 982 to explain why it is not taxable. So in the end, Ned filed his tax returns forms rather happily because he would not be taxable for his forgiven debts.

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Category: Finances
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