What is the threshold for exclusions of debt income when the taxpayer is insolvent?

When a taxpayer is insolvent, the tax code allows for the exclusion of canceled debt income up to the amount by which the taxpayer is insolvent. This means that if a taxpayer has debts that exceed their assets, any debt that is canceled is not included in their taxable income up to the total amount of insolvency.

For instance, if a taxpayer's liabilities are $50,000 and their assets are $30,000, they are insolvent by $20,000. If $15,000 of debt is forgiven, only up to $15,000 can be excluded from income because it does not exceed the taxpayer's amount of insolvency. If the debt canceled were greater than the insolvency amount, only the insolvent amount would be excluded.

This treatment provides important relief to taxpayers who find themselves in financial distress, preventing them from being taxed on amounts that they cannot afford to pay. Hence, the correct response reflects the nuanced understanding of how federal tax law applies to insolvent taxpayers and their canceled debt.