What is the insolvency exclusion?
Under the insolvency exclusion the taxpayer may exclude COD that occurs while insolvent up to the amount of insolvency. Any COD income in excess of insolvency is taxable income. The extent of insolvency is the excess of the taxpayer's liabilities over the FMV of his assets immediately before the debt cancellation.
What is a cancellation of debt due to insolvency?
One of the most overlooked exclusions is the debt cancelled due to insolvency. Here is how it works: Say you negotiated to settle a credit card debt for $1000, where you originally owed $4,000. In this case you would receive a Form 1099-C with cancellation of debt income for $3,000, which is the amount of the debt discharged.
Is cancellation of debt income excluded from gross income?
In this case, your insolvency amount (the amount that your debts exceeded your assets) was $5,000. Since your insolvency was greater than the amount of the discharged debt, the cancellation of debt income is excluded from your gross income. If this is your situation, you should read IRS Publication 4681, Canceled Debts, Insolvency.