How to Handle a CP2000 for Cancellation of Debt

Receiving a CP2000 notice related to cancellation of debt can be confusing. A CP2000 is not a formal bill but a proposal from the IRS to adjust your tax return. This notice is automatically generated when income information reported by third parties, such as lenders, does not match the information you reported on your tax return. The mismatch usually involves cancellation of debt income that was not reported.

When a lender forgives a debt of $600 or more, they are required to issue a Form 1099-C, Cancellation of Debt, to both you and the IRS. If you received a Form 1099-C but did not report the forgiven debt as income, the IRS system flags the discrepancy. This results in a CP2000 notice proposing changes to your tax, which often includes additional tax, penalties, and interest.

Determining if the Debt Cancellation is Taxable

The Internal Revenue Code states that gross income includes income from the discharge of indebtedness. When a lender cancels a debt, you are no longer obligated to pay it back, which provides an economic benefit that is taxable. The principle is that the reduction of your liabilities without a corresponding reduction in assets increases your overall net worth, and this increase is treated as income.

A significant exception to this rule is the insolvency exclusion. Insolvency is a financial state where your total liabilities are greater than the fair market value of your total assets. This calculation must be performed for the moment immediately before the debt was canceled. If you are insolvent, you may exclude the canceled debt from your income up to the amount by which you are insolvent.

To illustrate, imagine that just before your credit card company forgave $8,000 of debt, you had total liabilities of $40,000. At that same moment, the fair market value of all your assets—cash, the value of your car, and personal belongings—was $25,000. In this scenario, you would be insolvent by $15,000 ($40,000 in liabilities minus $25,000 in assets). Since the amount of your insolvency ($15,000) is greater than the canceled debt ($8,000), you could exclude the entire $8,000 from your income.

While insolvency is a frequent reason for exclusion, other situations also qualify. Debt discharged in a Title 11 bankruptcy case is not considered taxable income. Another specific exclusion applies to qualified principal residence indebtedness, which is mortgage debt forgiven on your main home.

Information and Forms for Your Response

When you disagree with a CP2000 notice because you qualify for an exclusion, you must provide the IRS with specific documentation. The central document for this is Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. For individuals claiming the insolvency exclusion, the process involves checking the box on Part I, line 1b, which indicates the discharge occurred while you were insolvent.

On line 2 of Form 982, enter the amount of canceled debt you are excluding, which cannot exceed the amount of your insolvency. You must also substantiate your claim by preparing a supporting document called an insolvency worksheet.

Your insolvency worksheet is a personal balance sheet that should be clear and organized. Create one section for assets, listing items like cash on hand, bank account balances, the current market value of your home and car, and any investments. In a separate section, list all your liabilities, including mortgage balances, car loans, student loans, and outstanding credit card debts.

Finally, you should draft a concise cover letter to include with your response. This letter should state that you disagree with the proposed changes in the CP2000 notice. Explain that you are excluding the cancellation of debt income under the insolvency exclusion and reference the enclosed Form 982 and supporting insolvency worksheet.

How to Submit Your Response to the IRS

Assemble your response package correctly to ensure efficient processing. Your response letter should be the first page, followed by the completed Form 982 and your supporting insolvency worksheet. It is also a best practice to include a copy of the original CP2000 notice you received.

The CP2000 notice will specify the address where you need to send your response; do not send it to a general IRS address. To ensure your response is received and you have proof of submission, use a mailing service with tracking. Using USPS Certified Mail with a Return Receipt provides you with a mailing receipt and a signature confirmation when the IRS receives it.

Once you have mailed your response, the IRS will review the documentation. If your explanation and supporting documents are sufficient, you will receive a follow-up letter confirming the proposed changes have been reversed and the case is closed. This review process can take 60 to 90 days. Should the IRS have further questions, they will send another letter requesting additional information.