Everything to know about financial insolvency

You might feel stuck in a financial pickle when you’re insolvent, and for good reason. Insolvency has a bad reputation, suggesting insurmountable money struggles, mountains of debt and no way out.

Insolvency may be a financial challenge, but it’s not the end of the world. Understanding this concept and knowing the tools to lead you out of it can get you on the path to financial health — and keep you there.

What is insolvency?

When you’re solvent, you have more assets than liabilities. In other words, you have enough cash (or can sell assets of value to get that cash) to pay expenses, bills and loans with no trouble.

Insolvency is the opposite. The IRS defines insolvency as when your total liabilities exceed your total assets. In other words, you don’t have the money to pay off that electric bill, credit card balance or mortgage. You might not earn enough to cover expenses, or your costs may have grown too high for your income to cover them.

You might not need to worry about short-term or temporary insolvency, especially if you expect an injection of money to help you pay off expenses. However, failure to pay attention could turn that temporary insolvency into a long-term problem.

Types of insolvency

Insolvency is divided into two categories: cash flow and balance sheet.

Cash-flow insolvency: Lacking liquidity

Cash-flow insolvency means you don’t have cash or cash equivalents to pay your debts. It may include:

• Not having enough income available to pay your mortgage/rent, utilities, credit card debt or other expenses in a timely or consistent fashion
• Taking on a new loan or activating another credit card but being unable to pay for that extra debt because your income hasn’t increased

You can determine cash-flow insolvency with a simple test. If you don’t have enough money to pay your bills when they’re due and constantly have to shuffle money around, you could be cash-flow insolvent.

Balance-sheet insolvency: Assets versus liabilities

As the name suggests, balance sheet insolvency focuses on assets and liabilities rather than cash flow and expenses:

• Assets are tangible or intangible items like revenue or income, valuable collections or personal property.
• Liabilities define what you owe others, such as lenders, creditors or vendors.

The balance-sheet insolvency test measures your assets against your liabilities. If the latter overwhelms the former, it suggests you don’t have the means to pay what’s due. Most of the time, this type of insolvency involves company operations.

Don’t assume that carrying a little debt means you or your company are insolvent. Taking debt is reasonable as long as your assets and liabilities are equal or your assets exceed your liabilities. You might not have cash equal to debt, but you could sell your assets off to meet those debts when needed.

The time to worry is when your liabilities exceed your assets, with little indication that the situation might change. This situation can quickly turn into cash-flow insolvency.

Insolvency and bankruptcy: Separate and not equal

One misconception is that the terms insolvency and bankruptcy are interchangeable. The confusion is understandable. Both situations stem directly from financial problems, but that’s all they have in common.

Bankruptcy involves lawyers, court orders, judgments or decrees under U.S. Code: Title 11, better known as the Bankruptcy Code.

As such, bankruptcy is a legal status. Insolvency is not.

Insolvency details a situation with insufficient cash or cash equivalents to pay expenses or debts. Bankruptcy is the final step of insolvency. You might have to declare Chapter 7 (total liquidation), Chapter 11 (reorganization) or Chapter 13 (debt readjustment) when you’ve exhausted all other methods of reducing or eliminating your debt.

How to get rid of insolvency

If you deal with insolvency early enough, you could avoid asking the courts for bankruptcy relief. Some procedures that could help you resolve insolvency include credit counseling, debt settlement and asset liquidation.

Credit counseling

Credit counseling organizations help you learn better money and debt management. In many cases, you could come away with a debt management plan.

While credit counseling can be helpful for budgeting and debt-management advice, it doesn’t eliminate all your debts.

Debt settlement/debt relief

Through debt settlement you negotiate with creditors for better payback terms. This might focus on reducing the amount you owe if you promise to pay in full. The creditors forgive the remainder of what you owe, or you might get a lower monthly payment or reduced interest rate.

You can settle the debt yourself or pay a fee to a debt settlement company to take care of the process. These companies often provide some elements of credit counseling and debt relief services. Many debt relief companies have you consolidate your debt with them, and they make payments to your creditors while negotiating.

Debt settlement can be expensive. It can also take a while, during which time your credit score may drop while payments are negotiated. The forgiven debt may also be taxable, which also adds potential costs to your tax bill.

Furthermore, not all debt relief agencies are reputable, so do your homework before choosing a company.

Asset liquidation

With liquidation, you sell your assets to generate cash to pay your creditors. Selling off your house, equipment or baseball card collection to resolve debt may allow you to pay off your creditors more quickly.

However, there are a couple of caveats to consider with asset liquidation. First, it might treat the symptom (the overwhelming debt) but not the cause (poor financial management). Without knowing how you became insolvent in the first place, you could find yourself there again.

Second, selling assets could trigger state and federal capital gains taxes. Selling real estate could also generate depreciation recapture taxes. You might eliminate debt and insolvency, only to find that you owe a lot of money to the IRS.

How to claim insolvency from the IRS

As noted, the IRS considers any forgiven or written-off debt (outside of bankruptcy court) as taxable income. Lenders or other creditors must submit Form 1099-C to the IRS when they forgive or cancel a debt of $600 or more.

You could invoke the insolvency exclusion by proving to the IRS that you were insolvent at the time of the debt forgiveness. Here’s what happens when you claim insolvency with the IRS:

1. Analyze the fair market value of your assets against your liabilities. Assets are things like your house, car, furniture, retirement accounts or jewelry. Liabilities are mortgages, home equity loans, credit card debt or student loans. If the value of your liabilities is higher than that of your assets, the IRS considers you insolvent.
2. Exclude debt from taxable income. Once you prove insolvency, you could exclude that forgiven or written-off debt from your taxable income based on the difference between asset and liability values.

For example, if your Form 1099-C reports $1,000 of canceled debt and your liabilities are $500 more than your assets’ fair market value, you can exclude $500 from your gross income. To do this, you must file Form 982.

You can only claim balance-sheet insolvency to the IRS, not cash-flow insolvency.

How to move forward after insolvency

Insolvency can be stressful and daunting, especially if it leads to bankruptcy. However, you can move on after insolvency and keep it from happening again with the following methods:

• Adopt new financial habits. Following insolvency, it’s a good idea to analyze why you ended up there to avoid similar future mistakes. Take the time to adopt a budget to determine what’s coming in and going out. Be sure to pay your bills on time. If possible, put a little extra into savings or investments.
• Work with a financial advisor. Financial advisors are typically associated with retirement planning for high-wealth individuals. In truth, these professionals manage all aspects of finances for people in all income classes. The right financial advisor can help you with budgeting, taxes, savings and investments. Be aware that financial advisors collect a percentage of your assets under management or charge a fee.
• Rebuild your credit. Insolvency, especially that leading to bankruptcy, could mean a low credit score. You can build your credit by taking steps such as obtaining a secured credit card backed by a cash deposit as collateral. Once you prove you can make consistent, on-time payments, the credit card issuer might upgrade you to an unsecured card. Don’t generate too much debt on that credit card — doing so could lead you back to insolvency.

In short, insolvency can help you better understand and take control of your finances. Take steps to steer clear of your previous mistakes, carefully budget income and expenses and avoid taking out loans you can’t afford.

Above all, don’t beat yourself up over financial mistakes. Instead, learn from the process and be ready to move forward to a happier and healthier financial life.