Taxes, Insolvency and the Bankruptcy Estate - John R. Dundon II, Enrolled Agent
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Taxes, Insolvency and the Bankruptcy Estate

Taxes, Insolvency and the Bankruptcy Estate

You are insolvent when your liabilities exceed the Fair Market Value (FMV) of your assets. It is important to determine your liabilities and the FMV of your assets immediately before the cancellation of debt to determine whether or not you are insolvent and by how much. Exclude from your gross income debt canceled when you are insolvent up to the amount by which you are insolvent.

To the extent that you find yourself insolvent, the insolvency exclusion takes precedence over qualified farm debt or qualified real property business indebtedness exclusions. The principal residence exclusion takes precedence over the insolvency exclusion, unless otherwise elected according to IRC section 108(a)(2)(C).

For example say you experienced a mortgage loan modification. If $40,000 of liabilities are canceled outside bankruptcy, and immediately before the cancellation the liabilities totaled $210,000 and the FMV of its assets was $170,500. Because its liabilities were more than its assets, it was insolvent. The amount of the insolvency was $30,500 ($210,000 − $170,500). You exclude only $30,500 of the $40,000 debt cancellation from income because that is the amount by which you are insolvent. You must also reduce certain tax attributes by the $30,500 of excluded income. The remaining $5,000 of canceled debt must be included in income.

ALWAYS REMEMBER – 

1. You must use the amount excluded to reduce certain tax attributes using IRS Form 982.

2. Bankruptcy exclusion takes precedence over the insolvency, qualified farm debt, qualified real property business indebtedness, or qualified principal residence indebtedness exclusions when cancellation of debt occurs in a Chapter 11 filing.



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