There are two types of insolvency. The first type is cash flow insolvency, which means that you are unable to pay your debts when they become due. The second type of insolvency is balance sheet insolvency, which means that your liabilities exceed your assets. It is possible to be balance sheet solvent, yet be cash flow insolvent, if you have your assets tied up in investments that are generally not liquid. This has been the case for many taxpayers this year, as they face foreclosure because they are unable to pay their monthly mortgage payments.
A taxpayer reaches insolvency when their liabilities exceed their total assets. Generally, you must include forgiven debt as income on your tax return. If you are insolvent and you have debt forgiven by a lender, you can exclude that debt from income on your tax return through the insolvency exclusion. Many taxpayers fell into a situation in which the value of their home decreased to the point that they owed more on their mortgage than the current value of their home. These homeowners could qualify for the insolvency exclusion.
The amount eligible to be excluded is limited to the amount that your liabilities exceed your assets. In addition, if the debt cancelled is related to operating a farm and qualifies under the tax code, you may not have to report it as income.
Bankruptcy
Chapter 12 or 13
Individuals that file a petition for Chapter 12 or 13 of the Bankruptcy Code should continue to file the same federal income tax return. Include all income received during the year on your tax return. However, do not include any debt canceled in income on your return. You must reduce losses in property by the amount of cancelled debt.
Chapter 7 or 11
When you file for bankruptcy under chapter 7 or 11 of the Bankruptcy Code a separate estate is created that is made up of property that belonged to you prior to the filing date. The bankruptcy estate is a separate entity from you as a taxpayer. Under chapter 7, the estate is placed in the care of a trustee appointed by the court to liquidate your nonexempt assets. In a chapter 11 filing, the debtor stays in control of the estate as a debtor-in-possession. All wages and income following the bankruptcy filing are yours and not subject to the obligations of the bankruptcy estate. If your bankruptcy filing is rejected, you will have to amend your taxes with a 1040X as if you had never filed the claim.
You must file or efile an income tax return during the period of bankruptcy proceedings. However, you should not include income, deductions, or credits belonging to the separately created bankruptcy estate. You have the option of ending the tax year on the day prior to submitting your bankruptcy petition.
Keep in mind that if you are filing for bankruptcy after January 1 of a given year, any tax refund that you receive during that year, even if you haven't yet filed your taxes, should be declared as an asset in your bankruptcy.
