8134 / What is the insolvency exclusion and in what manner must the taxpayer reduce certain tax attributes?
Pursuant to the insolvency exclusion, the discharge of debt income realized by an insolvent taxpayer is excluded from gross income to the extent of the taxpayer’s insolvency. So, if the discharge causes the taxpayer to become solvent, the amount of discharge that renders him or her solvent does not qualify for the exclusion. As determined immediately prior to the discharge, a taxpayer is insolvent to the extent his or her liabilities exceed the fair market value of assets.
In the following example, the debtor is insolvent before and after the liability is discharged. Therefore, the entire amount of discharged debt is excluded from gross income.
Example: A lender forgives Asher’s $200,000 recourse loan for no consideration. Prior to the discharge, the fair market value of Asher’s assets was $100,000 and the aggregate amount of his liabilities (including the $200,000 recourse loan) was $400,000. Therefore, prior to the discharge, Asher was insolvent to the extent of $300,000 ($400,000 liabilities minus $100,000 assets). Immediately following the discharge of the $200,000 loan, Asher remained insolvent to the extent of $100,000 ($200,000 liabilities minus $100,000 assets). Thus, the entire $200,000 discharged debt would be excluded from gross income.
Conversely, in the following example, the amount discharged causes the insolvent debtor to become solvent. As a result, only the amount of the discharged debt equal to the debtor’s pre-discharge insolvency is excluded from gross income. The balance (i.e., the extent of solvency) is included in gross income.
Example: A lender forgives Asher’s $200,000 recourse loan for no consideration. Prior to the discharge, the fair market value of Asher’s assets was $200,000 and the aggregate amount of his liabilities (including the $200,000 recourse loan) was $250,000. Therefore, Asher was insolvent to the extent of $50,000 ($250,000 liabilities minus $200,000 assets). Immediately following the discharge of the $200,000 loan, Asher became solvent to the extent of $150,000 ($200,000 assets minus $50,000 liabilities). As a result, only $50,000 (the extent of Asher’s pre-discharge insolvency) of the $200,000 discharged debt would be excluded from gross income. The other $150,000 (the extent of Asher’s post-discharge solvency) is included in gross income (as discharge of debt income) under IRC Section 61(a)(12).
Similar to a bankruptcy discharge, an insolvency discharge requires the taxpayer to reduce the listed tax attributes in the manner described in Q 8133, above.