Case — Discharge of Indebtedness Income – Insolvency Exclusion

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TL Case Summ

THE QUESTION

Does a taxpayer have to be insolvent both immediately before and immediately after having debt discharged in order to exclude the income from being taxed?

THE DISPUTE

Taxpayer Says: At the time mortgage debt was forgiven, taxpayer’s liabilities exceeded assets, so cancellation of indebtedness income is excludable from income.

Internal Revenue Service Says: The insolvency exception does not apply because taxpayer was not insolvent immediately after the mortgage debt was forgiven.

THE LAW

From Internal Revenue Code Section 61(a)(12): In general, the term “income” as used in the Internal Revenue Code means income from any source, including income from the discharge of indebtedness.

From Internal Revenue Code Section 108(a)(1)(B): Gross income does not include any amount which (but for this subsection) 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.

From Internal Revenue Code Section 108(d)(3): For purposes of section 108(a)(1)(B) the term “insolvent” means the excess of liabilities over the fair market value of assets as determined immediately before the discharge.

THE CAUSE OF THE DISPUTE

If you borrow money and cannot pay it back, your lender can “forgive” the debt, meaning you’re no longer legally responsible for repayment. Forgiveness of debt, also known as cancellation of indebtedness, generally results in taxable income.

Insolvency–when your debts are greater than the amount of assets you have available to repay those debts–is one of four exceptions to the general rule that cancellation of indebtedness income is taxable.

In this case, the IRS agrees taxpayer was insolvent prior to the cancellation of debt, but states taxpayer failed to establish insolvency immediately following the cancellation, so the insolvency exception does not apply.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 13KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
Sorry, wrong answer :(
For the Taxpayer. IRS relied on an inapplicable regulation and precedent from a case superseded by the enactment of section 108(a)(1)(B). Financial status of taxpayer immediately after the discharge is not relevant.
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