Cancelled Debt and Insolvency

If you like the blog, buy my book: Everyday Taxes 2016 both the kindle and print versions have detailed information on this topic, and links to an excel spreadsheet version of the INSOLVENCY WORKSHEET.  This is available only to book buyers.  The book is a must for everyone, regardless of how they do their taxes.

So you got a 1099C, or were informed by someone you owe money to that they're canceling some of your debt.  Maybe you were foreclosed on, had your car repossessed, or negotiated a settlement to pay a credit card less than what you owe.  If you haven't gotten a 1099C yet, you will.  Now is the time to get prepared.  I wrote an earlier post on cancellation of debt in general, which you should read before continuing: http://www.supertaxgenius.blogspot.com/2012/03/i-got-1099c-now-what.html

I'll wait...take your time...

Okay, so now let's talk about how to find out if you're insolvent.  First look at the 1099C, box 1 and note the date.  If you don't have the 1099C, use the date the debt was forgiven (you can call the lender to figure this out.)  You will use this date and figure out, as of that date, how much your assets were, and how much your liabilities were.  Your assets are everything you own, your liabilities are everything you owe.

We'll start with liabilities first.  Start with the debt that was canceled, the debt they canceled counts as a liability, so that's your first number.  Go to your credit cards, mortgages, car loans and any other money that you owe.  Print out the first statement after the date in question.  Now review the statement and determine what you owed as of our date.  You can do this by highlighting the beginning balance and any charges or payments up to our date.  Add the balance and charges, subtract any payments, and write this number on the statement.  Repeat for all of your debts, and then add them up to get a total amount of liabilities.  SAVE each of the statements!  The IRS can ask you to prove how insolvent you were.

Now assets.  Start with your bank accounts, brokerage statements, investments etc.  Print out each statement and highlight the value on the date in question.  For checking accounts, they usually keep a running total.  For brokerages, they may only give you a monthly balance.  If you can, go online and get the actual balance on our date.  Print the screen with this balance and keep it with the statement for that account.  If you can't get an exact amount, use the balance closest to our date.  Make sure to do this for your retirement plan at work (401K, 403B, TSP, etc.), as well as any Individual Retirement Accounts.

Now it gets harder.  For any vehicles you have, go to kbb.com or edmunds.com and determine the value of them.  You can use some judgment to get the best value (lower is better) but be reasonable.  If your car is truly a piece of s**t and you are using that to drop the value, take pictures to justify this assessment.  It's also not a bad idea to take a picture of the odometer reading.  Print the value you choose and highlight the value and attach it to any pictures you took.

Now you have to value everything else you own.  This is difficult.  Big, valuable items, take pictures and try to get a value off the internet - print any pages with values you use.  For your general household, pictures and video can be useful to prove you don't have fancy, expensive furniture.  Talk to a few people who know about values and try to get a good estimate.  I wouldn't do an appraisal unless you're really unsure, just make sure your values aren't ridiculous.

For your house (or houses) get a real estate agent to run comps and give you a written value estimate for them.  Save this paperwork.

Now the kicker.  This is updated due to recent litigation (Jan 2017): If you are receiving a pension such as state or federal retirement, union retirement, or private pension or annuity, you must figure out the value of your payments as a lump sum based on your life expectancy, IF you are able, based on the requirements of the plan and/or state law, to withdraw or borrow against the full value of the plan.  If you have no choice but to get the monthly payments, it is not an asset.  This is hard to figure out, and the number is usually an insolvency killer.  (I did several checks of my military retirement (which would no longer be included as an asset) from various sources and found values between $800,000 and $1.7 million.)  If you're close with everything else, this will probably prevent you being insolvent and is probably not worth the effort.

Now take all your liabilities and add them up.  Do the same with your assets.  Subtract assets from liabilities and if you get a positive number, you're insolvent!  This generally means you can avoid paying taxes on your cancelled debt up to the amount of your insolvency.

A couple words of warning:

1)  Save all the paperwork.
2)  Make sure to include the value of anything they repossessed in the asset column.
3)  If the debt cancelled was in your name (or your spouses) and not in the other's name, you have to calculate insolvency for the individual, not both of you (in this case include the full amount of anything in only the debtor's name, and split everything in both of your names.)
4)  If the numbers are close, make sure you have your ducks in a row.  If you lowballed the value of your household, or forgot to include your $3000 engagement ring, things can get ugly, and you could owe money back.  Conversely, if your liabilities are enormous, and you have tens of thousands of dollars of insolvency above your canceled debt, you can probably relax and not be quite as anal about household contents values (still do all the cars, house, big toys and bank accounts just like we said.)
5)  Insolvency affects tax attributes for future tax years.  This is way beyond the scope of a blog post, but you should seek professional assistance to determine the effect, especially if you have a business, investments, or rental property.

Don't forget the BOOK with the excel spreadsheet link!

Good Luck!