What is the IRS insolvency test?
You are insolvent for tax purposes when your total liabilities exceed the fair market value of your total assets immediately before a debt is cancelled. Under IRC Section 108, you can exclude cancelled debt from taxable income up to the amount by which you were insolvent.
How do I calculate insolvency for forgiven debt?
Add up all your liabilities and subtract the fair market value of all your assets, including retirement accounts and otherwise exempt property, measured just before the cancellation. If liabilities are greater, the difference is your insolvency amount, which caps the excludable forgiven debt.
How is the insolvency exclusion claimed?
You report it on IRS Form 982, attached to your tax return for the year of the cancellation. The lender still issues a Form 1099-C, but Form 982 lets you exclude the qualifying amount from income.
Is the tax insolvency test the same as bankruptcy insolvency?
No. The IRS insolvency test is a balance-sheet comparison for excluding cancelled-debt income and counts even exempt and retirement assets. Bankruptcy eligibility depends on the means test and the Bankruptcy Code, which use different definitions and exemptions.