One of life’s persistent gotcha’s is the tax consequence of having debt forgiven.

Did you compromise a debt, eliminate it upon foreclosure, or have your creditor simply wipe it out without payment. You may have a tax problem.

The tax code treats the forgiveness of debt as income, even though you never saw a penny of cash.

But there is hope (or a loophole, depending on your perspective).

Exceptions to canceled debt as income

Five exceptions will excuse you from paying taxes on canceled debt.

Insolvency is one.

If you are insolvent, the forgiven debt doesn’t get added to your taxable income.

Bankruptcy is the other big exception.  Debt wiped out in bankruptcy does not require you to account for the forgiven debt as income.

The bankruptcy exception often makes bankruptcy superior to debt settlement, and sometimes is itself the driving reason to file a bankruptcy before a foreclosure.

Are you really insolvent

Like much of the tax code, it isn’t simple to know if you are insolvent for these purposes.

The huge difference between the IRS treatment of your net worth and the way we address insolvency in bankruptcy is that the IRS includes retirement assets in the solvency calculation.

The last time I wrote about cancellation of debt and the possible tax surprise on foreclosure or short sale, I couldn’t lay my hands on the form the IRS provides to calculate insolvency.

Found it!

IRS publication 4681 contains the worksheet along with an explanation of the application of the principal that, absent an exception, debt canceled without payment is just like cash in the bank for tax purposes.

So, if you got a  form 1099 indicating your debt was canceled and it wasn’t a bankruptcy discharge that canceled it, get out the worksheet and see if you were insolvent when the debt was canceled.

Qualified principal residence exclusion extended through 2016

If you were insolvent by the IRS reckoning, check the box on Form 982 and submit it with your return.

More on debt forgiveness

• cancelled debts,
• how to handle 1099’s without paying
• tax consequences of foreclosure.
• deductions in your Chapter 13 payments