The Insolvency Exclusion and Form 982 After a Real Estate Loss

A lender forgave $90,000 on a mortgage. A Form 1099-C says so. Is the $90,000 taxable?

For many people dealing with a foreclosure or short sale in 2026, the answer turns on one exclusion: insolvency. The mortgage forgiveness exclusion for principal residences now applies only to discharges before 2026 or under written arrangements made before then. Investors were never eligible for it. Insolvency is the exclusion that is left, and it is often a good one, because people losing property are often insolvent. You just have to prove it.

The rule

IRC 108(a)(1)(B) excludes canceled debt from gross income if the discharge occurs when the taxpayer is insolvent. Two other provisions shape it:

• IRC 108(d)(3) defines insolvent as the excess of liabilities over the fair market value of assets, determined on the basis of the taxpayer's assets and liabilities immediately before the discharge.
• IRC 108(a)(3) limits the exclusion to the amount by which the taxpayer is insolvent.

So the exclusion is never more than the canceled debt and never more than the insolvency. Whichever is smaller wins.

Timing: immediately before the discharge

The balance sheet is a snapshot taken the moment before the debt is canceled. Not at year end. Not at the foreclosure filing. Immediately before the discharge.

That matters because foreclosures and discharges are often separated by months or years. A recourse lender may foreclose in one year and settle the deficiency two years later. The insolvency test applies at the settlement, when your finances might look very different. The date on the 1099-C is a starting point for identifying the discharge, but it is not always the legal discharge date. See the Form 1099-A and 1099-C guide for why.

Building the balance sheet

Publication 4681 includes an insolvency worksheet that walks through categories of assets and liabilities. Use it, but understand what each line is doing.

Assets at fair market value

• Cash and bank accounts
• Real estate, including any property not yet foreclosed, at market value
• Vehicles, at what they would actually sell for
• Retirement accounts such as IRAs and 401(k) plans, which the worksheet lists as assets
• Cash value of life insurance
• Investments, business interests, and partnership interests
• Household goods and personal items, at realistic resale value

Liabilities

• The full balance of every mortgage, including the one about to be forgiven
• Home equity lines, car loans, student loans, credit cards, and medical bills
• Unpaid federal and state taxes, including any IRS balance secured by a federal tax lien
• Obligations as a guarantor of someone else's loan, only to the extent they are real liabilities at that moment
• Judgments and other debts

Include the debt being canceled as a liability. The test is immediately before the discharge, when that debt still exists.

A worked example

Assume a Bradenton homeowner whose lender agrees to forgive a $90,000 deficiency after a short sale. Immediately before the forgiveness, the homeowner has:

Assets (fair market value)		Liabilities
Bank accounts	$4,000	Mortgage deficiency	$90,000
Car	$12,000	Car loan	$15,000
IRA	$30,000	Credit cards	$18,000
Household goods	$5,000	IRS balance	$25,000
Total	$51,000	Total	$148,000

Liabilities exceed assets by $97,000. The canceled debt is $90,000. Because the insolvency exceeds the canceled amount, the full $90,000 is excludable. If the IRA had been $90,000 instead of $30,000, insolvency would drop to $37,000, and $53,000 of the canceled debt would be taxable. Retirement accounts move the line more than people expect. These numbers are illustrations only.

Common mistakes

• Leaving out retirement accounts or the cash value of insurance.
• Valuing assets at what you paid rather than what they would sell for. A boat is worth what a buyer will pay.
• Measuring at the wrong date. Year-end figures are convenient and often wrong.
• Counting contingent liabilities at full value when they are unlikely to be paid.
• No documentation. Keep statements and valuations as of the discharge date with your return.

The price of the exclusion: attribute reduction

Excluded income is not free income. IRC 108(b)(1) requires the excluded amount to reduce your tax attributes, and IRC 108(b)(2) sets the order:

1. Net operating losses
2. General business credit carryovers
3. Minimum tax credit
4. Capital loss carryovers
5. Basis of your property, under IRC 1017
6. Passive activity loss and credit carryovers
7. Foreign tax credit carryovers

For a real estate investor with suspended passive losses from rentals, that list matters. Excluded debt can consume losses you were counting on to offset future rental income or a future sale.

IRC 108(b)(5) lets you elect to apply the excluded amount first to reduce the basis of depreciable property. That can preserve net operating losses or capital loss carryovers in exchange for lower future depreciation and a larger gain on a later sale. The decision depends on which attribute is worth more to you.

Filling out Form 982

Attach Form 982 to the return for the year of the discharge:

• Part I, line 1b: check the box for discharge of indebtedness to the extent insolvent, not in a title 11 case.
• Line 2: the total amount of discharged debt excluded.
• Part II: the attribute reductions. Line 5 is the 108(b)(5) election to reduce depreciable basis first. Lines 6 through 13 track the statutory order, and line 12 covers passive activity loss and credit carryovers.

If the exclusion is partial, report the taxable portion as income and the excluded portion on Form 982. The numbers must reconcile with the 1099-C, or the IRS will ask why.

When insolvency is not enough

If insolvency covers only part of the debt, look at the other exclusions. Investors with business real estate may elect the qualified real property business indebtedness exclusion for some of the rest, as described in the QRPBI guide, though IRC 108(a)(2)(B) applies insolvency first. A title 11 bankruptcy case excludes discharged debt without regard to solvency. For a principal residence with a written workout arrangement made before 2026, see the mortgage forgiveness guide.

Insolvency is arithmetic. Do the arithmetic as of the right day, keep the proof, and the exclusion holds.