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Proving insolvency to the IRS could reduce the tax bill

Even though the country is no longer in the midst of a recession, some Massachusetts families still struggle financially. Many of them work out deals with their creditors to reduce their debt, and that may include having some balances forgiven, which means that the company that extended credit for a home, car or other debt absolves the consumer of responsibility for a portion of the debt. The problem is that the IRS usually considers this forgiven debt as income and that could mean a hefty bill at tax time.

Some Massachusetts families avoid having to pay taxes on debt forgiveness through a bankruptcy discharge. What happens to those families who choose not to file for bankruptcy? Are they simply stuck with the tax bill on those forgiven balances? Fortunately, bankruptcy is not the only way to avoid including those balances as income when it comes to paying taxes.

The IRS allows taxpayers to declare that they are "insolvent," which means that their debts are more than their assets. When taxpayers' finances are upside down, meaning that they have more liabilities than assets, they can file a form with the taxing agency indicating that certain forgiven debt should not be included as income due to insolvency. It sounds simple, but the IRS will not simply take the word of individuals who file this form.

Instead, the IRS will require documentation establishing that a particular taxpayer was insolvent as the time the debt was forgiven. Providing adequate proof may not be as simple as it sounds. Massachusetts residents who want to take advantage of this potential tax savings will probably need assistance in making their case, especially since the difference could save thousands of dollars, depending on the circumstances.

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