I really hate to say I told you so — ok, no I don’t. Several months ago I warned that the recent change in regulations requiring the reporting of debt forgiveness to the IRS was going to result in people exchanging freely dischargeable credit card debt for non-dischargeable tax debt. Lots of people called me Chicken Little.

You see, there is an exception to the requirement that forgiveness of debt is taxable as gross income. That exception is for debt discharged in a Bankruptcy or forgiven while the taxpayer is insolvent. However, that exception defines insolvency as having more debts than assets — and it doesn’t say anything about excluding exempt assets.

Early this year the U.S. Tax Court entered a summary opinion finding that the exempt value of the tax payers’ homestead was included in adding up their assets for purposes of the Tax Code’s insolvency test. The Tax Court found that this couple who cut deals with their credit card companies and paid a substantial amount on their debts did not qualify as insolvent, because of their exempt homestead equity.

The couple were clearly insolvent for purposes of the Bankruptcy Code. If they had filed for bankruptcy, they would have discharged the total liability to the credit card companies. Instead, they tried to do the better thing — and exchanged freely dischargeable credit card debt for non-dischargeable tax debt.

This is not a published tax opinion, and I hate to splash this poor couple’s name across the blogosphere, so I am not linking to the opinion. If you have need for it, contact me by email.

Elaine