Exempt Property Not Excluded in Calculating Insolvency Exception

The case of Quartemont v. Commissioner, T.C. Summary Opinion 2007-19 (Jacobs, J.) illustrates the tax consequences of the settlement of debt at less than the full amount and specifically addresses the calculation of "insolvency" for the insolvency exception to the discharge of indebtedness income provision of the Internal Revenue Code. 26 U.S.C. 108. In this case, the taxpayers negotiated with their credit card companies to pay a lesser amount than what was owed instead of filing for bankruptcy relief. By their settlements with the credit card companies, they were able to cancel about $77,000 in debt. The I.R.S. determined that the $77,000 in cancelled debt was additional income.

The taxpayers claimed that the $77,000 in cancelled debt was not income based on the insolvency exception of 26 U.S.C. 108(a)(1)(B) which provides that gross income does not include any amount which would be includable in gross income by reason of the discharge of indebtedness if the discharge occurs when the taxpayer is insolvent.

The I.R.S. and the taxpayers did not agree on whether the taxpayers were insolvent at the time of the discharge of indebtedness. Insolvency is defined in section 108(d)(3) as the "excess of liabilities over the fair market value of assets." The taxpayers claimed that they were insolvent by arguing that their home should not count as an asset since it would be an exempt homestead in bankruptcy.

The tax court disagreed with the taxpayers and found that the calculation of insolvency does not exclude exempt assets. The court found that "assets" as used in section 108(d)(3) includes assets exempt from the claims of creditors under applicable state law.

The tax court noted that had the taxpayers filed for bankruptcy relief instead of reaching a settlement with their creditors, the discharged amount would not have been included in income as section 108(a)(1)(A) provides that gross income does not include any amount which would have been includable in gross income by reason of the discharge of indebtedness if the discharge occurs in a bankruptcy case.Jordan E. Bublick is a Miami Personal Bankruptcy Lawyer with over 25 years of experience in filing chapter 13 and chapter 7 bankruptcies. Miami Personal Bankruptcy Lawyer Jordan E. Bublick has filed over 8,000 chapter 13 and chapter 7 cases.