Whenever a debt is forgiven (which means it has been canceled through a debt settlement), it's possible the debtor will be required to report the forgiven debt as taxable income. If the forgiven amount is more than $600, it must be reported as taxable income. However, there are two exceptions to this rule: (1) the forgiven debt has been discharged through bankruptcy or (2) you are insolvent. You will need to total up all of your assets and liabilities to determine if you are insolvent.
Wait for the creditor you settled with to mail you a Form 1099-C. You should receive this form by Jan. 31. If you owed a credit card balance of $10,000 and you settled for $7,000, the creditor will send you a 1099-C reporting the $3,000 amount that was forgiven. The creditor must send a copy of this form to the IRS as well reporting that the debt has been forgiven. A cancellation date will appear on the form.
Make a list of all of your assets including stocks, bonds, checking and savings account balances, 401Ks, IRAs, CDs, jewelry, computers, home furnishings, automobiles and other assets. When your list is complete, assign a fair market value to each item. Verify that all of your assets are listed and correctly valued. Add up the fair market value for each item on your list to arrive at a total. The assets on your list must be those you owned on the cancellation date shown on your 1099-C form.
Make a list of every debt you owe, including your mortgage, auto loans, credit cards, lines of credit, home equity loans, tuition and educational loans. Total up your debts and write down the amount of your liabilities. Include everyone you owe on this list. Compare your total assets and your total liabilities. If your liabilities exceed your assets, you are insolvent and you don't have to report your forgiven debt as taxable income on line 21 of your 1040 tax return.
Prepare Form 982 and attach it to your tax return. This is how you notify the IRS that you are insolvent. You will need to attach some paperwork confirming that you are insolvent. It would be wise to get help from a tax professional. Otherwise, call the IRS as you are filling out Form 982 and they may be able to walk you through the steps to get it completed.