What Is the IRS Definition of Insolvent?

When a creditor forgives a debt, the Internal Revenue Service (IRS) generally considers that canceled amount as taxable income, as it increases your net worth. A lender who cancels $600 or more of debt is required to send you and the IRS a Form 1099-C, Cancellation of Debt. A significant exception to this rule is the insolvency exclusion.

The IRS allows you to exclude canceled debt from your income if you can prove you were insolvent at the time of the cancellation. For tax purposes, insolvency is a specific condition defined by a precise calculation, not just a general feeling of financial distress.

The IRS Insolvency Test

The IRS uses a balance sheet test to determine insolvency by subtracting your total liabilities from the fair market value (FMV) of your total assets. If your liabilities are greater than your assets, you are insolvent, and the difference is the extent of your insolvency.

The timing of this calculation is important. The test must be performed immediately before the cancellation of debt occurs, using a complete financial picture of every asset you own and every debt you owe at that specific moment.

This precise timing prevents individuals from manipulating their financial standing to qualify. For example, you cannot sell assets after the debt is canceled and then claim their value should not be included, as the financial snapshot must reflect your situation just prior to the forgiveness.

Calculating Your Assets and Liabilities

Accurately performing the insolvency test requires a comprehensive inventory of your financial life by identifying and valuing everything you own and owe.

Determining Your Assets

To calculate your total assets, you must identify everything you own and assign it a fair market value (FMV). FMV is the price a willing buyer would pay to a willing seller for the item, with neither being under any compulsion to buy or sell. This includes cash in bank accounts, the value of stocks and bonds, the current market value of your home and other real estate, and the resale value of personal property like vehicles, jewelry, and furniture.

A common point of confusion involves assets exempt from creditors, such as retirement accounts. For the insolvency test, the IRS requires you to include the value of all your assets, even those protected from creditors. This means the full value of your retirement accounts and other exempt property must be counted.

Determining Your Liabilities

Calculating your total liabilities involves adding up all your debts. This list should include the full balances on mortgages, home equity lines of credit, car loans, student loans, credit card debt, medical bills, and any other legally enforceable debts.

A point of frequent confusion is how to treat the debt being canceled. For the insolvency test, the full amount of the debt that is about to be forgiven must be included in your total liabilities. This is because it is still a legal obligation immediately before the moment of cancellation.

Applying the Insolvency Exclusion

Once you have calculated the extent of your insolvency, you can determine the amount of canceled debt to exclude from your income. The amount of forgiven debt you can exclude is limited to the amount by which you are insolvent.

For instance, imagine your total liabilities are $75,000 and the fair market value of your total assets is $60,000. This means you are insolvent by $15,000. If a creditor cancels a $20,000 credit card debt, you can exclude $15,000 of that canceled debt from your income.

The remaining $5,000 of the canceled debt must be reported on your tax return as “Other Income.” The exclusion shields you from tax only to the extent of your negative net worth, and any debt forgiveness that makes you solvent is taxable.

Reporting Insolvency to the IRS

Claiming the insolvency exclusion is not automatic; you must formally report it by filing Form 982, Reduction of Tax Attributes. This form must be attached to your federal income tax return for the tax year in which the debt was canceled. Failing to file can lead to an IRS notice for an income tax deficiency, as their records will show the canceled debt from Form 1099-C without the corresponding exclusion.

On Form 982, you will specify the amount of canceled debt you are excluding from income and check the box indicating the exclusion is due to insolvency.

A condition of using the insolvency exclusion is the reduction of certain tax attributes. Tax attributes are items that can lower your taxes in the future, such as net operating losses or capital loss carryovers. The amount of canceled debt you exclude from income reduces these attributes dollar-for-dollar, which can affect your future tax liabilities.