Cancelation of debt should generally be reported as an income on your tax return, but luckily there are three exceptions:
For purposes of relief under the cancellation of debt income rules, you are insolvent if the total of all of your liabilities was more than the fair market value (FMV) of all of your assets immediately before the cancellation. For purposes of this calculation, your assets include the value of everything you own liabilities include the entire amount of recourse debts (debts that you are personally responsible for but not guaranteed with specific collateral, like your credit cards), the amount of nonrecourse debt (secured debt, like a mortgage).
If under the tax laws, you were insolvent immediately before the cancellation of debt, you would not include that canceled debt in income. Generally, your canceled debt would be reported to you on a form 1099-C. Of course, the lending institution or bank which issued you the form 1099-C does not know that you qualify for an exception so you are going to have to let the IRS know why you are not including the amount of that 1099-C in income for tax purposes. You do this by completing a federal Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. The IRS also offers Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals) to assist you with the insolvency calculations.
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