Insolvency & COD income

[bruehaus]

I know that a taxpayer can exclude COD income if, before the event, they can prove that they were insolvent. And the amount excludable is limited to the amount of insolvency. However, if the taxpayer is still insolvent after the COD event can they exclude all of the COD even if it exceeds the amount they were insolvent before? In other words, if the taxpayer is still insolvent after the COD event, then there is no limit to the amount of COD that can be excluded because they have only reduced their insolvency.

Is this correct?

[joanmcq]

They can exclude income up to the amount they are insolvent by.

[Koss]

Insolvency

I know that a taxpayer can exclude COD income if, before the event, they can prove that they were insolvent. And the amount excludable is limited to the amount of insolvency. However, if the taxpayer is still insolvent after the COD event can they exclude all of the COD even if it exceeds the amount they were insolvent before? In other words, if the taxpayer is still insolvent after the COD event, then there is no limit to the amount of COD that can be excluded because they have only reduced their insolvency.

Is this correct?

What the code looks at is the amount by which they were insolvent immediately before the debt was cancelled. Because the determination is made immediately before the cancellation, the cancelled debt itself is included in the calculations that determine whether the taxpayer was insolvent, and by how much.

If they remain insolvent after the cancellation of the debt, then it follows logically that they were insolvent by more than the amount of the cancelled debt. Therefore the entire amount of the cancelled debt could be excluded.

But mathematically, there will always be some upper bound to the amount of debt that can be excluded. There are no real-world conditions that would create a situation in which the taxpayer could exclude an "unlimited" amount of cancelled debt. In order for this to occur, the taxpayer would have to be insolvent by an infinite amount.

Burton M. Koss
koss@usakoss.net

[veritas]

Here is a recent case

Keith v Commissioner, T.C. Summary 2007-214

In a nutshell they defaulted on their home loan.

The bank generated a 1099c with a loan balance of 112,035 and fmv of 90,000.

Cancellation of debt reported by the bank was 22,035.

The IRS tried to take the position that they must be insolvent before and after the debt discharge.

The tax court ruled their financial status immediately after the debt discharge was irrelevant.

The numbers before the discharge were assets of 133,715 and liabilities of 155,505.

So the court found that the Keith's liabilities exceeded their assets by 21,790.

So in the end they had to include 245 in income, the difference between cancelled debt of 22,035 and 21,790.