Any time that you have a lender who forgives or cancels a debt that you owe, the IRS requires that they send you a 1099-C to report the amount of debt that was cancelled. This then becomes taxable income to you. I realize that it is not really income, in the sense that you earned money, but in the eyes of the IRS it is treated as income since you received something in the form of goods or services or cash which you did not have to repay.
When the lender issues the 1099-C form, a copy is also sent to the IRS which is how they know this was not reported on your return. It's possible that your copy of the 1099 was lost in the mail or perhaps sent to the wrong address, but in any case, you will now have to deal with this situation.
When you have a cancellation of debt, there are really only two ways you can avoid paying tax on the this. One is if the debt was discharged through a bankruptcy filing. That is no an option for you at this point since the debt was from so many years ago.
The only other option is if you can show that you were insolvent at the time the debt was forgiven, meaning that at the time this happened your liabilities were more than your assets.
In order to claim insolvency and not pay tax on the debt which was forgiven, you must file Form 982 with the IRS. You will check the box on Line 1b indicating you are requesting exclusion based on insolvency.
You should attach some documentation to show how you determined you were insolvent at the time the debt was forgiven. This can be a simple listing of your assets and liabilities. Here is an example:
House - $100,000
Car - $10,000
Checking Account - $1000
Misc. personal property - $2,000
Total Assets: $113,000
Home Mortgage: $80,000
Car Loan: $7,000
Credit Car Debt: $30,000
Total Liabilities: $117,000
Total Insolvency = Assets ($113,000) minus Liabilities ($117,000) equals (-$4,000)
In the above example, someone could exclude $4,000 from the amount of cancelled debt they had to report, so in order to exclude the entire amount, your total insolvency would have to be the same amount or more than what was reported on the 1099-C form.
The Form 982 is included as part of your actual tax return for the year this happened. So if you wish to try and claim insolvency, you will need to file an amended tax return with the IRS for that year, and include this form.
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