My condolences and I am sorry you are going through this stressful situation.
It is questionable whether or not you would have to file a Final Form 1040 or report this on Form 1041 for the estate to report this cancellation of debt.
Basically what the tax laws say is that if the debt was cancelled after the taxpayer's death, the cancellation of debt would be considered income of the estate (Form 1041).
If the Estate has more than $600 of income a Form 1041 has to be filed. Cancellation of debt after the death of the taxpayer is income to the estate and it reportable to the extent the estate is solvent.
There are no assets of the estate so is it solvent? You could reasonably argue no.
The only worry I would have is the from the last paragraph below regarding the IRS. Because of this I would consult an attorney or tax professional that specializes in decedents tax returns, regarding this just to be safe.
As far as filing a final Form 1040, in general, file and prepare the final individual income tax return of a deceased person the same way you would if the person were alive. Report all income up to the date of death and claim all eligible credits and deductions.
The filing of the deceased taxpayer's final return usually falls to the executor or administrator of the estate, but if neither is named, then the task needs to be taken over by a survivor of the deceased. The final return is filed on the same form that would have been used if the taxpayer were still alive, but "Deceased:" is written at the top of the return followed the person's name and the date of death. The deadline to file a final return is the tax filing deadline of the year following the taxpayer's death.
If the taxpayer was married, the spouse may file a joint return for the year of death, claiming the full standard deduction, and using joint-return rates.
The executor usually files a joint return, but the surviving spouse can file it if no executor or administrator has been appointed. If the surviving spouse has a qualifying dependent and meets other requirements, they can file as a qualifying widow/widower for the two years following a spouse's death. That basically lets you continue to use the same tax brackets that apply to married-filing-jointly returns. Otherwise, the surviving spouse can file a joint return for the year of death.
Taxpayers whose spouses died during the tax year are considered married for the entire year, provided they did not remarry. The surviving spouse is eligible to file as Married Filing Jointly or Married Filing Separately.
So as you can see it does get a little sticky and it would be advisable to consult an attorney or a tax professional that specializes in decedent tax returns.
From the Tax Laws:
If a debt of a taxpayer is canceled after the death of the taxpayer, the cancellation of debt income is income to the estate or the non-grantor trust of the decedent and reportable as income on the 1041 return for the estate or non-grantor trust (Reg. 1.108-9(c)(2)) to the extent the estate or non-grantor trust is solvent.
The Code Sec 108(a)(1)(B) insolvency exclusion applies to estates and non-grantor trusts just as it applies to individuals, so the cancellation of debt income, is only taxable to the extent the estate or non-grantor trust is solvent and would be reportable on the 1041 return.
Generally, COD income is taxable to the estate under Section 61(a)(12) and reported on Form 1041. The resulting tax liability is payable by the estate. However, if the estate is insolvent, COD income is excludable to the extent section 108 applies, i.e., to the extent the estate’s liabilities exceed its assets.
The IRS has the authority to assess the beneficiaries of the insolvent estate for the tax owed by the estate under the transferee provisions of IRC Sec 6901. A transferee for purposes of Sec 6901 includes beneficiaries who have received property from the estate. While the transferee assessment and collection process is the same under Sec 6901, strict statute of limitations periods apply and the burden of proof is on the IRS. (See Section 6902).
Click here for how to file a final tax return for someone who has passed away.
Click here for additional tax information when there is a death in the family.
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