If you are the beneficiary of any type of forgiven or canceled debt, your former creditor will send you a Form 1099-C at the end of the year. Form 1099-C lists the type and amount of your canceled debt. You must usually report this information to the Internal Revenue Service, which considers canceled debt to be taxable income. In some instances, particularly bankruptcy or insolvency, you may be entitled to a forgiveness of the taxation on your 1099-C canceled debt.
Collect all of your Form 1099-Cs. If you had more than one debt forgiven or settled, you will receive a separate 1099-C from each creditor. If you overlook any of them, you may not be able to forgive the taxation of the canceled debt.
Look at box 6 of each 1099-C. If you had your debts canceled as a result of filing bankruptcy, your creditors should have checked this box, marked "Check for bankruptcy."
Get a copy of Form 982. You can get blank copies from the IRS or any tax preparer. Formally entitled "Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)," Form 982 is the required document to forgive your tax obligation on Form 1099-C.
Check box 1a of Form 982 if you filed bankruptcy. Even though Form 982 refers to "Title 11" bankruptcy, you should check this box no matter what chapter of bankruptcy you filed. Title 11 refers to a U.S. Code section covering all bankruptcies, not just a Chapter 11 bankruptcy.
Check box 1b of Form 982 if you did not file bankruptcy but are legally insolvent. Insolvency for IRS purposes means the total amount of your liabilities exceeds the total amount of your assets. To help you determine if you are insolvent, complete the Insolvency Worksheet in the IRS Publication 4681. If you are claiming insolvency without bankruptcy, you must also complete Part II of Form 982, "Reduction of Tax Attributes." Essentially, Part II of Form 982 reduces the cost basis of your possessions by the amount of your debt, so you may have to pay capital gains tax on any possessions you later sell.
Enter the amount you want forgiven from taxation on line 2 of Form 982. Typically, this amount will equal the canceled debt totals from your 1099-C forms.
Attach Form 982 to Form 1040 when you file your tax return. Assuming your figures are correct and the IRS accepts your entries, you will not have to pay tax on the amount of canceled debt you list on line 2 of Form 982.
If you are claiming insolvency or reducing the basis of any property, the calculations for avoiding tax can be complicated. You may wish to consult a tax adviser.