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You may be able to defer recognition of some or all of the debt discharge income by establishing that you were insolvent at the time the debt discharge was effected. Insolvent means that your liabilities (i.e. all debts) exceeded the fair market value of all your assets. To accomplish this you need to prepare a personal financial statement as of the day before your debt was discharged. A personal financial statement would show all your assets at their then fair market value and all your outstanding liabilities. If the liabilities exceed the value of your assets, then you may defer recognition to the extent of the excess of the liabilities over the assets.
However, if order to take advantage of this exception you must file form 982 (Reduction of Tax Attributes...) located at http://www.irs.gov/pub/irs-pdf/f982.pdf. The cost to avoiding recognition of the debt discharge income, is that you must reduce your some tax benefit you have. This may mean reducing any capital loss carry forwards, credits or even the cost basis of your principal residence if you own your home.
First, if you are electing to reduce basis or other tax attributes (i.e. capital loss carryovers, etc.) you may only reduce to the extent of your insolvency. Thus if your debts exceed your assets by $10,000 (prior to discharge) then you may only defer recognition of canceled debt as income to the extent of the insolvency (i.e. $10,000). If the debt cancelled exceeds the insolvency amount you must recognize it as income.
To properly complete Form 982 you would check box 1b in Part I. In Part II you would start entering amounts on each line in order to the extent you have the applicable assets or attributes.
If you do not operate a business or have real property used in a business ignore lines 4 through 7. Line 8 refers to alternative minimum tax credit you may be carrying forward from a prior year. If you do not have any AMT Tax credit ignore this line as well. Line 9 refers to any capital loss carryforwards you may have from prior reported losses on Schedule D that you were unable to deduct. If you have some capital loss carryfowards then you will enter on this line the lesser of the capital loss carryforward or the debt discharged (in which case your done with the form). If you do not have any capital loss carryforwards ignore line 9.
Line 10 is used if you have other depreciable or non-depreciable property (i.e. a principal residence, rental residence, autos, furnishings, etc.). You may enter the lesser of your cost basis or the remaining discharged debt not claimed on lines 4-9. Please note that you are limited in the amount you may reduce your cost basis in these types of assets to the excess of your cost basis over your other non-discharged debt. For example, assume you have qualifying assets whose cost basis is $30,000 and other non-discharged debts and liabilities of $20,000. If you have discharged debt of $15,000 you may only defer recognizing as income $10,000 of the cancelled debt since your property cost basis only exceeds your other debt by $10,000. The remining $5,000 would have to be recognized as income.
Line 11 is if the debt discharged was qualified fam indebtedness. Line 12 may be used if you have suspended passive activity losses or related credit carryovers available to reduce. Finally, line 13 is applicable if you have any foreign tax credit carryovers available to reduce.
To the extent you have reduced your cost basis in all available assets and you still have cancelled debt, you must recognize it as income.
Let me know if you have other questions of if you do own and operate a business to which lines 4-7 may apply.
Because it is impossible for me to identify and consider ALL the relevant facts, this advice is not intended or written to be used for the purpose of avoiding penalties, and cannot be used for that purpose.
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