Insolvency Exclusion Used With Other Exclusions

People often will qualify to exclude debt cancellation under multiple exclusions.  This often happens when the taxpayer qualifies in part under the Mortgage Forgiveness Debt Relief Act (the “Act”), but they have additional debt cancellation that related to a second mortgage or a cash out refinance. 

This cash may have been used to buy a car, pay off credit cards, or pay medical bills.  In each of these cases, the debt will not apply under the Act so the taxpayer will need to look to other exclusions.  Since the Act only covers qualified principal residence indebtedness, you should first look to the insolvency exclusion. 

For example, assume a principal residence is secured by mortgage debt of $300,000, of which $225,000 represents qualified principal residence indebtedness. If the residence is sold for $200,000 and $100,000 of the debt is discharged, only $25,000 of the debt discharged may be excluded from income ($100,000 that was discharged minus $75,000 of nonqualified debt). The remaining $75,000 of nonqualified debt may qualify in whole or in part for one of the other exclusions, such as insolvency.

People often assume that if it is their personal residence they automatically don’t have any debt cancellation income.  This is certainly not the case.