12.3.1 Insolvency

A common exclusion of “debt cancellation income” from taxable income results if the taxpayer was insolvent in the year that the debt was cancelled. “Insolvent” means that the taxpayer’s liabilities exceed the fair market value of the assets.1  This is a common option for removing cancelled debt income as many creditors only cancel debt after determining that the taxpayer is insolvent. Obtain a copy of the taxpayer’s credit report for that taxable year, which should list all the taxpayer’s debts.

Income in excess of insolvency is includible in a partially insolvent taxpayer’s income.2  The insolvency exclusion won’t apply to a discharged debt to which the § 108(a)(1)(E) exclusion for “qualified principal residence indebtedness” applies unless the taxpayer elects the § 108(a)(1)(B) insolvency exclusion. Cancellation of a debt that would have been deductible if paid, e.g., mortgage interest, is excluded from income.3

In Carlson v. Commissioner, the Tax Court has held that exempt assets, e.g., a homestead exemption for the family home, must be included in determining whether a taxpayer is “insolvent.”4  Some consideration should be given to challenging Carlson since it has been criticized.

Another issue is whether a separated spouse’s assets must be included in the insolvency analysis. Prior to Carlson, the IRS had issued a private letter ruling that a spouse’s separate assets should not be considered in determining whether the other spouse is insolvent for the purposes of the § 108 exclusion.5

• 1I.R.C. § 108(d)(3).
• 2I.R.C. § 108(a)(3).
• 3I.R.C. § 108(e)(2).
• 4Carlson v. Comm’r, 116 T.C. 87 (2001).
• 5Priv. Ltr. Rul. 8920019 (Feb. 14, 1989).