Insolvency Or Bankruptcy – Which Debt Cancellation Exclusion Do You Qualify For?
If a taxpayer cannot exclude all debt cancellation income based on the Mortgage Forgiveness Debt Relief Act (the “Act”), there may be relief to them if they can prove they were insolvent just prior to the date of the debt forgiveness.
You are insolvent when (and to the extent) your total liabilities exceed the fair value of all of your assets. For purposes of determining insolvency, your assets would include the value of everything you own. This would even include assets that serve as collateral for debt and exempt assets that would normally be beyond the reach of creditors under law, such as pension plans and the value of any retirement accounts.
Liabilities would include the entire amount of recourse debts and the amount of any nonrecourse debt that would not be in excess of the fair value of the property that is secured by the debt. You can exclude from your gross income debt canceled when you are insolvent, but only up to the amount by which you are insolvent. You must, however, reduce the basis of certain assets.
If a debt is cancelled under a title 11 bankruptcy it would normally not be included in taxable income. Insolvency is a finite calculation that is completed at a date in time, while bankruptcy is a significant and lengthy process. Whether or not you should file bankruptcy is a complex decision and should not be taken lightly.
Taxpayers may be able to avoid immediate tax implications through either insolvency or bankruptcy. Make sure to do your own diligence to determine which is best for you.