Insolvency isn't doomsday—here's why

Most of us know that being insolvent isn’t good, but we don’t know exactly what it means or why it’s bad. (That’s because it’s always bad on TV shows and in movies.)

In fact, in some cases, being insolvent could be a good thing. Being insolvent could actually help you at tax time and make it easier to get rid of your debt through debt resolution.

What is insolvency?

In general, insolvency means financial trouble. There are two types of insolvency.

Cash flow insolvency

Cash flow insolvency means not being able to pay your bills when they come due. This could easily happen if you live paycheck-to-paycheck and you lose your job. It could also happen if you have a sudden large expense. An emergency vet bill, for instance, might not leave you enough cash for your rent. 

Balance sheet insolvency

Balance sheet insolvency means that the total amount you owe on your debts is greater than the value of what you own. It’s a completely different calculation. You add up all your debts—mortgage, credit card balances, student loans, auto loans, and so on. Then, add up the fair market value of your assets (car, house, furniture, electronics, art, jewelry, bank account balances and investments). Compare the two totals. If your assets (what you own) are worth less than the total of your debts (what you owe), that means you’re balance sheet insolvent. 

Insolvency doesn’t have to be serious

While the term “insolvent” sounds bad, insolvency isn’t necessarily serious or even unusual. When you’re just starting out, you may own very little, and it’s normal to live paycheck to paycheck. If you don’t get paid on time that week, you might become cash flow insolvent. But then your check arrives and you’re good again. You pay back the friend you bummed pizza money from and move on. 

It’s also easier to become balance sheet insolvent when you don’t own much. Suppose you buy a new car with zero down. As soon as you drive it off the lot, it becomes a used car, and its value falls. You’re now balance sheet insolvent. Or you charge a vacation on a credit card. You now have debt and no assets. (Experiences are wonderful, but they don’t count as assets.) However, as long as you can comfortably cover your bills, temporary balance sheet insolvency won’t ruin your life. 

When insolvency is a warning sign

The examples above demonstrate that insolvency is often a temporary situation and not serious. However, insolvency that lingers or gets worse should concern you. 

Credit card accounts, for instance, could be pretty deceptive because their minimum payments are so low. You might be able to easily afford your minimum payments even while you rack up too much debt. Balances that take years to pay off. Debt that couldn’t be cleared even if you sold everything you own. Insolvency might be telling you that you’re spending more than you earn, and that’s impossible to sustain. 

In this case, insolvency is telling you to take action. Reset your finances. Get help if you need it.

How to tell if you’re insolvent

Cash flow insolvency means you don’t have enough money or ready credit to pay your bills on time. You might own a house, a car, a priceless Star Wars collection, whatever, but your credit card company won’t take those things. If your fixed expenses exceed your income, that means you’re cash flow insolvent. 

If you bring home $4,000 a month from your job and your necessary payments are $4,200, you’re insolvent by $200. 

Balance sheet insolvency is the only one recognized by the IRS. If your assets are worth $500,000, and your debts total $550,000, you’re $50,000 insolvent. 

You can calculate your balance sheet insolvency by adding up the current value of your assets. Subtract the total of all your debts. The IRS publishes a simple worksheet you can start with.

When insolvency is severe

Insolvency is severe when you don’t see a way out. If your necessary expenses exceed your income every month, putting you further in the hole over time, you need help. That’s serious cash flow insolvency. You have to cut your costs or increase your income, or the math just won’t work.

Here are a few solutions when you can’t earn more and there’s no wiggle room in your budget:

• Contact your creditors and explain the problem. Let them know what they can do to help you afford your payments. They may be willing to cut your interest rate, payment, or balance to keep you from defaulting. 

• If you can’t get enough assistance from your creditors, consult a debt resolution professional. These experienced negotiators could create a plan for you and negotiate your debts for you. 

• Bankruptcy is an option. It takes place in the court system, so creditors can’t opt out of the process. 

How insolvency affects debt resolution

Insolvency could impact your potential debt solutions in a couple of ways:

• First, if you can show creditors that you’re cash flow insolvent (your payments exceed your income), they’ll see that you truly can’t afford the full amount of your debt. This could make them more willing to help you. 

• Second, normally, forgiven debt is taxable as income. But if you’re balance sheet insolvent (your debts exceed your assets) and your creditors forgive a portion of your debt, those amounts aren’t taxed by the IRS. Note that only forgiven amounts that are less than your insolvency are tax-free. If you’re $50,000 insolvent, you won’t owe federal income tax on up to $50,000 on debt forgiveness. 

• Amounts forgiven in bankruptcy are generally tax-free.

If bankruptcy is on the table as a possible option and you’re trying to find out whether you qualify for Chapter 7 (the clean slate bankruptcy), you’ll take a means test. That’s a calculation comparing your income to your debt obligations. Cash flow insolvency might matter in this situation. (There are other factors that will be considered, and the best person to advise you is a bankruptcy attorney.)

If you’re worried about your debt, try calculating your insolvency. Both types. The answer may help you determine how serious your problem is and point you to the best solution. Talking to a debt expert could help you understand your options.