The Insolvency Exclusion is an addition to the Debt Forgiveness Relief Act of 2007. Insolvency is created when the debt liabilities are higher than the fair market value of the borrower’s assets. This usually is the case for people who have lost their homes. Before the forgiveness event (foreclosure, short sale), all of your liabilities are listed with their fair market values. The IRS has explained insolvency exclusion as (found in Publication 908):
“You are insolvent when, and to the extent, your liabilities exceed the fair market values of your assets. Determine your liabilities and the fair market value of your assets immediately before the cancellation of your debt to determine whether or not you are insolvent and the amount by which you are insolvent.”
This can also be found in Publication 4681: Cancelled Debts, Foreclosures, Repossessions, and Abandonment’s” http://www.irs.gov/pub/irs-pdf/p4681.pdf. The publication has also provided a calculation page for you to make this calculation. If insolvency has been determined, you must report this on your tax return.
Pursuant to IRS regulations, you do not include canceled debt as income, assuming you were insolvent before the cancellation. Your IRA, vested pension plans, properties, and assets that were used as collateral are included. You should also include assets that would otherwise be exempt in a bankruptcy.
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