One of the exceptions to inclusion of your cancellation of debt income is the Insolvency Exception. This is in addition to the exclusion provided by the Mortgage Debt Forgiveness Relief Act of 2007. In fact, in terms of ordering you use the Act first if it applies and then the inslovency exception.

Pursuant to the IRS regulatios, you do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation. This means everything. Your IRA's, vested pension plans, other properties, the assets that serve as collateral for the debtm etc are included. You even include assets that would otherwise be exempt in a bankruptcy.

Liabilities include:

  • The entire amount of recourse debts,
  • The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt, and
  • The amount of nonrecourse debt in excess of the FMV of the property subject to the nonrecourse debt to the extent nonrecourse debt in excess of the FMV of the property subject to the debt is forgiven.

To report to the IRS that you are excluding canceled debt from income under the insolvency exclusion, attach Form 982 to your federal income tax return and check the box on line 1b. On line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately before the cancellation. You must also reduce your tax attributes in Part II of Form 982.