Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent. IRC Section 108(a)(1)(B)
This can provide a more tax advantaged way of getting out of debts if the taxpayer is solvent. A solvent taxpayer wanting to use this exception can sometimes do a “prepackaged” chapter 11 filing with their creditors agreeing on the reorganization plan prior to filing.
Insolvency means that the taxpayer’s liabilities exceed his assets. IRC Section 108(d)(3).
All of the taxpayer’s assets and liabilities count for purposes of determining insolvency, including exempt property, and liabilities securing exempt property. See, FSA 199932019, Carlson v. Comm’r, 116 T.C. 87 (2001); In re Wommack, 74 B.R. 638 (Bankr. N.D. Fla. 1987). This “balance sheet” approach is consistent with the bankruptcy Code definition of insolvency. 11 U.S.C. Section101(31).
For taxpayers with significant exempt property, a bankruptcy filing may be advantageous because the applicability of the insolvency exception may be questionable, and the bankruptcy exception does not contain an insolvency requirement.
The amount of COD income excluded under the insolvency exclusion is limited to the amount of the taxpayer’s insolvency. IRC Section108(a)(3).