Under which circumstance can the taxpayer exclude all income from their canceled debt?

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A taxpayer can exclude all income from canceled debt under specific circumstances related to insolvency. The key factor is that if the taxpayer’s liabilities exceed their assets, they are considered insolvent, which allows for the exclusion of canceled debt from taxable income.

In this case, the correct scenario involves having $11,500 of debt canceled while being insolvent by $12,000. This means that the taxpayer's total liabilities were $12,000 greater than their total assets at the time the debt was canceled. Since the amount of canceled debt ($11,500) is less than the total amount by which the taxpayer was insolvent ($12,000), the entirety of the canceled debt can be excluded from income.

This allows the taxpayer to avoid taxation on that canceled debt, as the financial situation clearly shows they were in a worse predicament than the amount of debt forgiven.

The other scenarios do not demonstrate this balance of insolvency relative to canceled debt. In each case where exclusion was considered, the taxpayer’s insolvency was either insufficient to cover the entire canceled debt amount or did not fall within the necessary parameters set forth by tax regulations for exclusion. Thus, only in the situation where the debt amount is fully covered by the insolvency can the taxpayer exclude

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