How Insolvency Works
Under IRC Section 108(a)(1)(B), you can exclude cancelled debt from income to the extent you were insolvent at the time of cancellation. Insolvency means your total debts exceed your total assets. If your debts were $50,000 and your assets were $30,000, you were insolvent by $20,000 and can exclude up to $20,000 of cancelled debt income.
This is the most commonly used exclusion for consumer debt cancellation. Many people who settle debts, have debts written off, or receive 1099-Cs for old debts qualify for full or partial exclusion because their debts exceeded their assets at the time.
Calculating Insolvency
Total debts include: All debts -- credit cards, medical bills, student loans (even non-dischargeable ones), mortgage balance, auto loans, personal loans, judgments, tax debts, everything you owe. Total assets include: Cash, bank accounts, retirement accounts (yes, include these even though they're exempt from creditors), real estate equity, vehicle equity, personal property, investments, and business interests.
Calculate both totals as of immediately before the cancellation. If debts > assets, you're insolvent. The exclusion is limited to the amount of insolvency. Example: debts $80,000, assets $60,000, cancelled debt $25,000. Insolvency = $20,000. You can exclude $20,000 but must include $5,000 as income.
Filing Form 982
To claim the insolvency exclusion, file IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) with your tax return. Check Box 1b ("Discharge of indebtedness to the extent insolvent"). Enter the excluded amount on Line 2. Attach a worksheet showing your insolvency calculation (debts and assets).
Keep detailed documentation: credit reports showing all debts, bank statements showing account balances, property valuations, retirement account statements -- all as of the date immediately before the debt was cancelled. If audited, the IRS will want to verify your insolvency calculation.
Frequently Asked Questions
Do I include retirement accounts in my assets for insolvency?
Yes. Unlike bankruptcy exemptions, the insolvency calculation includes ALL assets -- even retirement accounts that would be exempt from creditors. This can reduce or eliminate your insolvency if you have significant retirement savings.
Can I use insolvency for mortgage debt cancellation?
Yes, the insolvency exclusion applies to all types of debt cancellation, including mortgage deficiencies from short sales or foreclosure. There's also a separate exclusion for qualified principal residence indebtedness, though its availability has varied by year.
What if I was partially insolvent?
If your insolvency amount is less than the cancelled debt, you exclude the insolvency amount and include the remainder as income. Example: $10,000 cancelled, $7,000 insolvent = exclude $7,000, report $3,000 as income. Even partial exclusion can significantly reduce your tax bill.
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