How insolvency affects your debt and your taxes

By Gina Freeman

Reviewed by James Heflin

Feb 25, 2024

Read time: 6 min

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Key takeaways:

  • The IRS defines insolvency as having more debt (what you owe) than assets (what you own).

  • Insolvency impacts how much you could save when negotiating your debt or filing bankruptcy.

  • You can be insolvent without going bankrupt, and you can go bankrupt without being insolvent.

Even if you can’t pay your bills today, you don’t have to struggle forever. Your situation today doesn’t define you; it only tells you what your starting point is. Let’s explore how insolvency affects your financial landscape and discover a few strategies that could help you regain control and move toward a more stable financial future. 

We’re not tax professionals and although we can offer general information, we cannot offer tax advice. Please reach out to a tax professional to discuss your specific situation.

What is insolvency?

Insolvency generally means being unable to pay your bills. Insolvency sounds complicated, but it can be pretty simple. And in fact, being insolvent could give a leg up to your financial recovery plan. Whether you’re insolvent or not determines how much debt you can wipe out in a bankruptcy filing—and how much income tax you might owe on forgiven debt.

In the United States, there are two ways to be insolvent:

  • Cash flow insolvency means you don’t have money to pay your bills as they come due. This situation is often temporary. You might, for example, try to get around a shortfall with an overdraft or cash advance. However, if you’re consistently short, your cash flow problems may get too big for a quick fix.

  • Balance sheet insolvency means your total debts are greater than the value of everything you own. That’s a more serious situation because even if you sold everything, you couldn’t completely clear your debts. Balance sheet insolvency is the only kind recognized by the IRS.

Why does insolvency matter?

Insolvency can impact your taxes if your lenders stop pursuing you for a delinquent debt (or charge off your account). It also comes into play if you resolve debt for less than you owe or file bankruptcy. Here’s how.

If you resolve a debt for less than the balance owed or a creditor charges off your balance, you’re likely to receive a Form 1099-C at tax time. A 1099-C tells the IRS that a creditor canceled all or part of your debt during that tax year. The IRS considers canceled debt to be taxable income—unless you can show that you’re balance sheet insolvent.

You don't have to be insolvent to file bankruptcy. Your main concern is which of your assets are exempt (protected from creditors), and which are non-exempt (unprotected). That has nothing to do with insolvency. That said, insolvency can indirectly affect ‌some bankruptcy filings:

  • If you are balance sheet insolvent, you wouldn't be able to pay off your debts even if you surrendered everything you own to a bankruptcy court. 

  • In a Chapter 7 bankruptcy, then, you’d lose all of your non-exempt assets. The bankruptcy trustee would sell them and give the proceeds to your creditors. You'd be allowed to keep exempt assets like work tools.

  • You can be balance sheet solvent and still lose nothing in a Chapter 7 if all of your assets are exempt.

  • Cash flow insolvency comes into play in a Chapter 13 filing. If you are cash flow insolvent, you can’t cover your debts and basic living expenses on your current income. 

  • You’d be required to pay income exceeding basic living costs into a Chapter 13 plan. However, the law requires you to pay at least as much under Chapter 13 as you would under Chapter 7. That means your monthly plan payments would have to total at least as much as the value of your non-exempt assets.

  • If you can’t afford a Chapter 13 payment that meets this requirement, you don’t qualify to file. Being too cash flow insolvent could derail a Chapter 13 filing.

  • If cash flow insolvency prevents you from filing Chapter 13 and you don’t qualify for or don’t want to file Chapter 7, debt resolution may be a better option. 

Debts wiped out in bankruptcy are not subject to income tax.

How does insolvency affect your taxes?

Debt that’s forgiven outside a bankruptcy filing is usually taxable, unless you’re insolvent.

The IRS only recognizes balance sheet insolvency. To calculate your insolvency, you simply add up all your debts (the balances you owe, not the monthly payments). Next, total the fair market value of your assets. Include all assets, even ones like retirement accounts that creditors can’t touch. If your debts exceed your assets, you’re insolvent. The IRS publishes a simple insolvency worksheet you can use. There's a slightly more detailed version in an informational booklet called Publication 4681. It’s the IRS’s instruction manual for dealing with canceled debts on your tax return. 

Here’s what insolvency might look like for an individual:


$ value


$ value

Home value




Car value


Auto loan


Household goods


Credit card balances




Student loans


Total assets


Total debts


$455,000 debt - $445,000 assets = $10,000 insolvency

It’s important to calculate insolvency before seeking debt forgiveness. If a creditor forgives $15,000 in credit card debt, you’d still include all $25,000 in current credit card balances in your insolvency calculation. 

The amount of insolvency matters. Forgiven amounts are only nontaxable when they don’t exceed your insolvency. For instance, if your creditors forgive $15,000 in credit card debt, but you’re only $10,000 insolvent, $10,000 of the forgiven debt won’t be taxed. You might owe income tax on the remaining $5,000 of forgiven debt.

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How do you prove you’re insolvent?

First, work your way through the insolvency worksheet. It tells you how to calculate insolvency, and provides examples. 

Next, complete IRS Form 982 to prove that you’re insolvent. Read the instructions carefully. You’ll check the box matching the reason you’re allowed to exclude forgiven debt from your taxable income and indicate how much debt you’re excluding. 

What are my options if I’m insolvent?

Insolvency doesn’t automatically mean you’re in financial hot water. The seriousness of a situation depends on how insolvent you are, and the type of insolvency you’re experiencing. Here are some examples of how different people might handle insolvency.

"House rich, cash poor"

The Jones family bought their home a few years ago, and the property's value has increased since. Their assets exceed their debts, so the Joneses aren't insolvent for tax purposes. However, the Joneses’ credit card balances and other debts have grown to the point that they are struggling to keep up with their bills on what they earn. They are cash flow insolvent. 

The Joneses could apply for a home equity loan for debt consolidation to consolidate credit card debts and other high-interest balances. They could end up with a lower total monthly payment, especially if they qualify for a lower interest rate than what they’re currently paying. A lower payment could help them manage their monthly budget. Debt consolidation works best if you avoid increasing your debt (i.e., charging the credit cards back up) while you’re paying off the consolidation loan.

"On the ropes"

The Smiths rent their home and live paycheck-to-paycheck. Unfortunately, illness and unemployment took their toll on this family. They used credit cards, cash advances, and payday loans to cover living expenses. They are a month behind on their rent, and the landlord is threatening to evict them. The only thing they own is a car worth about $2,000 and a bank account with $500. Between credit card balances, high-interest cash advances, and medical debt, they’re over $60,000 in the hole. They are balance sheet insolvent.

If the Smiths’ income doesn’t exceed the median income in their area (for their family size), they might qualify for Chapter 7 bankruptcy. That would stop their eviction (at least temporarily) and allow them to get rid of most or all of their debt while giving up almost nothing. The downsides of bankruptcy are that it’s public, involves filing fees (and often lawyer fees), and will impact their credit score.

"On the edge"

The Thomases recently finished college, married, and moved cross-country for new jobs at modest salaries. This family has $55,000 in student loans, plus $18,000 in credit card debt from the move. Their bills take up most of their income, and they can’t sleep at night knowing they can’t cover an unexpected expense. 

The Thomas family owns very little. They are cash flow solvent, but just barely. They’re balance sheet insolvent by around $40,000. Bankruptcy doesn’t look like a helpful option, however. Student loans are rarely discharged in bankruptcy, and their new jobs put their income over the median for a family of two in the area where they live. They qualify for Chapter 13, not Chapter 7. They’d be required to make a substantial monthly payment with the goal of paying off all or part of their debt. They’d also pay attorney fees and court fees. 

The Thomases take a two-pronged approach. First, they use debt resolution to resolve their credit card debt for less than they owe. Debt resolution has an impact on their credit standing, but the forgiven amounts aren't subject to income tax because they are insolvent. Next, they switch their student loans to an income-driven repayment plan, giving them some breathing room while they get their new careers started.

Insolvency is important, but it’s not everything

When you can’t afford to fully repay your debts and you’re weighing bankruptcy vs debt resolution, insolvency matters. That’s because amounts forgiven through debt resolution are generally taxable, while balances discharged in bankruptcy are not.

If you’re insolvent, though, amounts forgiven through debt resolution are not generally taxable. Resolving your debt without filing bankruptcy could be the best choice in that case because debt resolution has a few other advantages that might be important to you. 

When deciding how to deal with your debt, insolvency is just one piece of the puzzle. The type of debt matters, and so does the amount. Here are some questions to consider:

  • How much debt will you have to repay?

  • Do you have overdue child support, student loans, legal judgments or other kinds of debts that are difficult or impossible to wipe out in bankruptcy?

  • What will you be charged (for debt professionals, lawyers, filing fees, etc.)?

  • What will your tax liability be?

What’s next

You need good information to make a good decision about your debts. 

  • Look at the situation. Make a detailed list of your debts and income. 

  • Determine whether you’re balance sheet insolvent by completing the IRS worksheet.

  • Explore potential solutions, including debt consolidation, debt resolution, and bankruptcy. Get a free debt consultation to discuss your options.

  • Compare the costs and benefits and available solutions, and choose the best one for your situation.

Gina Freeman - Author

Gina Freeman has been covering personal finance topics for over 20 years. She loves helping consumers understand tough topics and make confident decisions. Her professional history includes mortgage lending, credit scoring, taxes, and bankruptcy. Gina has a BS in financial management from the University of Nevada.

James Heflin - Author

James is a financial editor for Achieve. He has been an editor for The Ascent (The Motley Fool) and was the arts editor at The Valley Advocate newspaper in Western Massachusetts for many years. He holds an MFA from the University of Massachusetts Amherst and an MA from Hollins University. His book Krakatoa Picnic came out in 2017.

Frequently asked questions

The top causes of insolvency leading to bankruptcy include financial hardships such as major medical expenses, job loss, an unaffordable mortgage, overspending, and divorce. 

Yes. Insolvency is a financial condition, while bankruptcy is a legal filing. You don’t have to be insolvent to go bankrupt. And you can be insolvent without going bankrupt.

Creditors can sue you if you don’t repay your debts as agreed. It doesn’t matter if you’re solvent or insolvent. If you’re being sued by a creditor, you may be able to stop the process by negotiating your debt or filing for bankruptcy protection.

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