Solvent or Insolvent? That’s the Solution For Debt Forgiveness

Solvent: the liquid in which a solute is dissolved to form a solution. No, that doesn’t sound right.

Solvent: having assets in excess of liabilities; able to pay one’s debts. We are getting closer.

Solution: a liquid mixture in which the minor component is uniformly distributed within the major component (the solvent). Nope, now we are getting colder.

Solution: a means of solving a problem or dealing with a difficult situation. Good, getting warmer.

Insolvent: A taxpayer is insolvent when his or her total liabilities exceed his or her total assets. Perfect! That’s what we are talking about.

Insolvency could be the solution for debt forgiveness

If a debt is forgiven or discharged for less than the full amount owed, the debt is considered canceled in the amount that you do not have to pay. Cancellation of a debt may occur if the creditor cannot collect, or gives up on collecting, the amount you are obligated to pay. If you own property subject to a debt, cancellation of the debt also may occur because of a foreclosure, repossession, a voluntary transfer of the property to the lender, abandonment of the property, or a mortgage modification.

In general, if you have cancellation of debt income because your debt is canceled, forgiven, or discharged for less than the amount you must pay, the amount of the canceled debt is taxable and you must report the canceled debt on your tax return for the year the cancellation occurs. The canceled debt is not taxable, however, if the law specifically allows you to exclude it from gross income.

Forgiven debt may be excluded as income under the “insolvency” exclusion.

The forgiven debt may be excluded as income under the “insolvency” exclusion; meaning the taxpayer does not have to include a canceled debt in income to the extent they were insolvent immediately before the cancellation. A taxpayer is insolvent immediately before the cancellation to the extent that the total of all liabilities was more than the FMV of all assets immediately before the cancellation.

Cash-flow insolvency and Balance-sheet insolvency

Cash-flow insolvency is when a person or company has enough assets to pay what is owed, but does not have the appropriate form of payment. Balance-sheet insolvency is when a person or company does not have enough assets to pay all of their debts. The person or company might enter bankruptcy, but not necessarily.

For purposes of determining insolvency, assets include the value of everything you own. Liabilities include:

  • The entire amount of recourse debts
  • The amount of nonrecourse debt that isn’t in excess of the FMV of the property that is security for the debt

And, the amount of nonrecourse debt in excess of the FMV of the property subject to the nonrecourse debt to the extent nonrecourse debt in excess of the FMV of the property subject to the debt is forgiven. (Yeah, you have to read that one a couple of times.)

Form 982 and the Insolvency Worksheet

To show that you are excluding canceled debt from income under the insolvency exclusion, attach Form 982 to your federal income tax return and check the box on line 1b. On line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately before the cancellation, using the Insolvency Worksheet to help calculate the extent that you were insolvent immediately before the cancellation.

If you have questions about whether your cancelled debt is taxable or if bankruptcy is the right choice for solving tax and financial challenges, call us for help. Contact the Florida offices of the www.taxproblemsolver.com  today to speak with a tax or bankruptcy attorney, CPA or IRS Enrolled Agent (EA). Call 407-629-5923 or 727-894-2099. Or email us at steve@TaxProblemSolver.com. #EnrolledAgent  We help people NATIONWIDE and are here to provide quality assistance to your most important financial issues. @HeinkelTaxLaw