Form 982 IRS: How to Reduce Your Tax Liability Through Debt Discharge?

Taking a secured or unsecured loan carries a certain risk, as you may be unable to pay it back if your financial circumstances change.

Sometimes a traditional or online lender can agree to forgive a portion of your debt. However, you must still include the discharged amount in your gross income in this scenario.

IRS Form 982 enables you to exclude the forgiven debt amount from your taxable income, but only if you qualify for an exemption. 

In this article, we’ll go through the ins and outs of Form 982 IRS to show you how and under which circumstances it can help reduce your tax liability.

Debt Discharge And Form 1099 C

Let’s start with the basics. 

A lender will attempt to collect a debt if a borrower misses two or more loan payments. For instance, a lender may initiate foreclosure if you skip three consecutive payments on a car loan. But they’ll probably contact you after the first missed payment.

However, suppose the collateral on the loan or the other assets you own are insufficient to cover the remaining debt. In that case, a lender can opt to discharge the debt.

According to Publication 4681: ‘if a debt for which you are personally liable is forgiven or discharged for less than the full amount owed, the debt is considered canceled in whatever amount it remained unpaid. You must include the canceled debt in your income.’

After debt discharge, you will receive Form 1099 C informing you that the lender has reported it to the IRS. The form can include the following codes that reveal why it was filed:

• Code A – Bankruptcy 
• Code B – Other judicial relief 
• Code C – Statute of limitations or expiration of deficiency period 
• Code D – Foreclosure election 
• Code E – Debt relief from probate or similar proceeding 
• Code F – By agreement 
• Code G – Decision or policy to discontinue collection 
• Code H – Other actual discharge before identifiable event

Box 2 of Form 1099 C will contain the amount of discharged debt, while Box 3 will show canceled interest, if any. If a lender cancels your debt, you must add this amount with interest to your gross income.

Insolvency, Bankruptcy, And Other Exemptions

The discharged debt amount can be excluded from income if the taxpayer qualifies for an exemption. You’ll have to file Form 982 if you qualify for an exemption from the rule that a canceled debt must be added to the income you report on the tax return.

Let’s look at exemptions that can reduce your tax liability after debt discharge.

Bankruptcy

You might be exempt from including a canceled debt in your income if the debt was discharged in a Title 11 bankruptcy case. Bankruptcy is a legal process during which your assets will be used to clear your debts.

To qualify for a bankruptcy exemption, a court must decide to cancel your debt. Afterward, you must file Form 982 with the tax return and provide the necessary information on Lines 1a and 2.

Insolvency

Being insolvent means that you owe more than the total worth of your assets. The IRS will consider all assets you own, including jewelry or furniture, when determining if you were insolvent before a lender canceled your debt.

You must claim insolvency by filing the necessary forms with the IRS and use the insolvency exemption of Form 982 after the IRS approves your claim.

Other Exemptions

The IRS may allow you to exclude a canceled debt amount from your income if you qualify for the following exemptions:

• Principal residence indebtedness
• Qualified farm indebtedness
• Debt discharge is a gift

Hence, if the discharged debt resulted from running a farm, a mortgage you took to buy or improve your home, or a gift from the lender, you can exclude the canceled debt amount from your income.

The maximum principal residence indebtedness amount you can exclude from income is $375.000 for filers with Single status or $750,000 for taxpayers with Married Filing Jointly status.

The IRS provides a long list of requirements you have to meet to qualify for these exemptions, so you must read Publication 4681 and Section 108, Income from Discharge of Indebtedness, before filing Form 982.

Form 982 And Tax Attribute Reduction

You’re required to recalculate the tax attributes when filing Form 982. The term refers to the reduction of adjusted property basis, tax credits, net operating losses, capital losses, and other tax attributes.

Taxpayers who qualify for debt discharge exemptions must reduce these tax attributes by the amount they exclude from their incomes. Doing so postpones taxation of canceled debt and prevents taxpayers from gaining an excessive tax benefit after a debt discharge.

The amount by which different tax attributes are reduced is included in Part II of Form 982, titled Reduction of Tax Attributes, in lines four through thirteen. Remember that tax attributes cannot be reduced below zero.

Publication 4681 states, ‘ the order in which tax attributes are reduced depends on the reason canceled debt was excluded from income.’

You must follow instructions for different exemptions to calculate the tax attribute reduction correctly. Moreover, you’ll have to determine if you can reduce these attributes dollar-for-dollar for the excluded debt amount or 1/3 of each dollar.

Tax attribute reductions can sometimes be used to lower a taxpayer’s annual income. But in most cases, you won’t be able to use them to reduce your taxes in the future.

Understanding When to File Form 982

You should only file Form 982 if you qualify for an exemption.

Debt discharge is usually the byproduct of a lengthy legal battle and negotiations with lenders, so you should be aware of your eligibility for an exemption long before you file federal taxes for the year when the debt was canceled.

Nonetheless, you should consult a tax professional before filing this form to ensure you meet all requirements and avoid further complications.

Taxpayers who qualify for an exemption from excluding canceled debts from their income should file Form 982 with the tax return before the filing deadline for the most recent tax year.

Filing an amended return with Form 982 is also an option if you don’t make certain elections or remove the canceled debt from your income before filing the original return.

Calculating the tax attribute reductions is the most challenging part of filling out Form 982. Here are the steps you may have to take to reduce tax attributes:

• Determine the total taxes due for the specific year and the tax attribute reduction rate (either dollar-to-dollar or 1/3 of a dollar).
• Establish basis reduction if applicable.
• Calculate capital and net operating losses and then add carryover losses from previous years.
• Reduce tax credits in the appropriate order.

Remember that the tax attribute reduction calculation depends on why a canceled debt was excluded from income.

Frequently Asked Questions

Using Form 982 IRS to Reduce Your Tax Liability Through Debt Discharge

The IRS treats all canceled debts as taxable income because you don’t pay taxes when you borrow money, so you’ll stand to benefit from debt discharge. As a result, you must report the canceled debt amount on your tax return as additional income.

Form 982 enables you to reduce the liability created by debt discharge by claiming exemptions that allow you to exclude the debt amount from the gross income.

However, this doesn’t mean that the IRS will forgive the taxes you owe for the discharged debt amount after you file Form 982. Qualifying for an exemption only gives you more time to pay taxes if you’re experiencing financial hardships.