You may not have to include it in income
When you are liable for a loan but can't repay it, some lenders will forgive the debt. What many borrowers don't realize is that this cancellation of debt results in taxable income in the year of forgiveness. The lender usually will issue a 1099-C to report the cancelled debt. If you receive one, don't ignore it. Be sure to give it to your tax preparer and discuss the circumstances surrounding the loan.
If you have cancelled debt but are bankrupt or insolvent, you may exclude the income on your tax return. To prove insolvency, your liabilities must exceed the fair market value of your assets immediately before the debt discharge. The amount of forgiven debt can be excluded cannot be more than the amount your liabilities exceed the value of your assets.
In light of the current mortgage crisis, Congress has provided more relief for borrowers who couldn't pay their mortgages. If you have forgiveness of debt on the mortgage of your qualified principal residence (usually due to foreclosure), you don't have to recognize cancelled debt. The maximum amount of debt forgiveness eligible for exclusion is $2 million. This relief is available for tax years 2007 through 2009.
