The general rule regarding cancellation of debt is that it is a taxable event. But there are some exceptions. The most common exceptions involve bankruptcy, the Mortgage Forgiveness Debt Relief Act (the “Act”), the insolvency provision, and certain farm and other business indebtedness.
If the cancellation of debt pertains to your primary residence and you don’t qualify under the Act, you may be able to exclude the income under the insolvency exclusion. You are insolvent when, and to the extent, the amount of your liabilities exceed the fair value of your assets.
To determine if you are insolvent (and the amount by which you are insolvent), you should analyze your liabilities and the fair value of your assets immediately before the debt cancellation event. Accordingly, the definition of insolvency would be when your liabilities exceed your assets at a given point in time.
Remember that the insolvency calculation should be done just before the cancellation of debt occurred. This can be difficult because often the cancellation of debt occurred several months back. Just realize how difficult the process is to go back six months to a year in the past and try to determine the balance in your bank account and the value of any furniture, vehicles, etc.
Your assets would include the value of everything that you own, including assets that serve as collateral for your debt and assets that would ordinarily be beyond the reach of creditors under the law, such as your 401k, pension plans and retirement accounts.
Liabilities would include your debt including the entire amount of recourse debt and the amount of nonrecourse debt that is not in excess of the value of the property that is held as security by the debt.
Assets you have may include (but are not limited to) the following:
Cash and bank account balances
All real property (including land)
Cars and other vehicles
Boats and other watercraft
Household goods and furnishings
Appliances, computers, electronics, etc
Clothing & books
Stocks, bonds and mutual funds
Investments in coins, stamps, paintings, or other collectibles
Firearms, tools, sports, photographic, and other hobby equipment
Interests in retirement accounts (IRA accounts, 401(k) accounts, etc.)
Interests in education accounts and cash value of life insurance
Security deposits with landlords, utilities, etc.
Value of investment in a business (including interests in partnerships)
Other investments (for example, annuity contracts, guaranteed investment contracts, and commodity accounts).
Liabilities you have may include (but are not limited to) the following:
Credit card debt
Mortgage(s) on all real property including 1st and 2nd mortgages
Car and other vehicle loans
Accrued or past due mortgage interest and/or real estate taxes
Accrued or past due utilities (water, gas, electric, etc.)
Federal or states income taxes remaining due (for prior tax years)
Loans from 401k accounts, other retirement plans and life insurance policies
Business debts (including those owed as a sole proprietor or partner)
Margin debt on stocks and other debt to purchase or secured by investment assets other than real property
Other liabilities (debts) not included above
The insolvency exclusion is complex and you should use a CPA or other tax or legal professional to assist you with the calculation. You must use proper diligence in determining the amounts on the solvency calculation. This includes proper support for the fair market valuations of assets and liabilities, which may include (but is not limited to) appraisals, independent valuations, market studies, account statements, etc. You must retain any and all supporting documentation relating to the insolvency calculation.
This article is written for informational purposes only and is not intended to be tax or legal advice. Each situation is different and you must discuss your situation with a qualified tax or legal professional. We inform you that any federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.