One of exclusions available to reduce the tax liability that comes with receiving a cancellation of debt is available by calculating your insolvency at the time of the discharge of debt.
Internal Revenue Code § 108(a)(1)(B) states that gross income does not include any amount which would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent.
If you were insolvent (meaning your total liabilities or debts exceed your total assets) you may exclude the discharged debt from your gross income. However, Code § 108(a)(3) states that the insolvency exclusion is limited by the amount of the insolvency.
To explain how this works more clearly let’s look at an example:
Tommy Taxpayer made deal with his credit card company, he agreed to pay half of balance immediately if the credit card company would forgive the rest. He later receives a 1099-C Cancellation of Debt that is to be included on his 2015 taxes in the amount of $10,000 for debt discharged in February of 2015. Tommy goes through his records from February of 2015 and finds:
Assets
- Bank Account $1,500
- Savings $5,000
- House $150,000 fmv
- Car $5,000 fmv
Total $161,500
Debts
- Mortgage balance $145,000
- Car Loan balance $8,400
- Credit Card balance $10,000
- Student Loan balance $4,000
Total $167,400
161,500 – 167,400 = -$5,900
If we subtract the total debts from the total assets we can see that Tommy Taxpayer’s insolvency is limited to $5,900. Since his cancellation of debt is for $10,000 he can exclude $5,900 of it from his income because the exclusion is limited to the amount he was insolvent. He will still be liable for the tax on the other $4,100 that will be included in his income.
Insolvency is one of a few different exclusions available when trying to reduce the tax liability associated with cancellation of debt. We’ll continue our look at Cancellation of Debt, the types of transactions, and other exclusions in future posts.