In which case will the taxpayer be able to exclude all income from their canceled debt?

To determine when a taxpayer can exclude all income from canceled debt, the criteria of insolvency must be thoroughly understood. Insolvency occurs when a taxpayer's liabilities exceed their total assets. When a debt is canceled, it generally results in taxable income; however, if the taxpayer is insolvent to the same extent or greater than the canceled debt, they can exclude that amount from their taxable income.

In this case, the third option describes a scenario where a taxpayer had $12,500 of debt canceled and was insolvent by $13,000 prior to the cancellation. Since the amount of the canceled debt ($12,500) is less than the amount by which the taxpayer was insolvent ($13,000), the taxpayer can fully exclude the canceled debt from their taxable income. This means that because their liabilities exceeded their assets by a greater dollar amount than the debt that was canceled, they can exclude the entire amount of the canceled debt from taxation.

This understanding of the insolvency exclusion is critical in determining tax liabilities related to canceled debts and highlights the importance of accurately assessing personal financial circumstances when dealing with such cancellations.