What to know about financial insolvency

Struggling to meet your financial obligations can be stressful and overwhelming. If you’ve reached the point of insolvency — meaning your debts exceed your assets —you may feel like you’re in a hopeless situation. Overcoming insolvency is a challenge, but it’s not impossible.

Understanding what insolvency means and learning about the tools available to address it are the first steps to helping you get back on track. With the right information and approach, you can work on regaining stability and improving your financial health.

Solvency vs. insolvency

Being “solvent” means 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.

Insolvency is the opposite. The IRS defines insolvency as having total liabilities that exceed your total assets. This could be due to earning too little to keep up with your expenses or having expenses that have escalated beyond what your income can handle.

When insolvency occurs, individuals or businesses may not have funds available to meet financial obligations.

Occasional short-term or temporary insolvency may not spell disaster, especially if you expect an injection of money to help you pay off expenses.

Types of insolvency

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

Cash-flow insolvency: Lacking liquidity

Cash-flow insolvency occurs when you don’t have cash or cash equivalents to pay your debts. Common signs include:

• Not having enough income to pay your mortgage/rent, utilities, credit card debt or other expenses on time or consistently.
• 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. You could be cash-flow insolvent if you don’t have enough money to pay your bills when they’re due and frequently have to shuffle money around.

Balance-sheet insolvency: Assets vs. liabilities

Balance sheet insolvency occurs when your total liabilities exceed your assets. This type of insolvency focuses on what you own vs. what you owe.

• Assets include tangible items like personal property and intangible items like income.
• Liabilities are what you need to pay back to others, including loans from lenders, bills from creditors, or payments to vendors.

To assess balance-sheet insolvency, compare your total assets and liabilities. If your debts exceed the value of everything you own, you may not have the means to pay what’s due. This type of insolvency typically pertains to business finances but may also impact individuals.

Don’t assume that carrying a little debt means you or your company are insolvent. Taking on debt is reasonable if you can repay it over time or your assets exceed your liabilities.

Even if you don’t have enough cash to pay off all debts, you’re likely still solvent as long as you could sell off assets to meet your debt obligations if necessary.

The time to worry is when your liabilities exceed your assets, with little indication that the situation might change. In this case, your circumstances could quickly turn into cash-flow insolvency.

Common factors that contribute to insolvency

A wide range of circumstances can lead to an individual’s or company’s insolvency. Some of the most common include:

• Economic downturns: Recessions or market declines that reduce business and personal income levels.
• High debt levels: Accumulating too much debt, especially with high interest rates.
• Increased expenses: Sudden or gradual increases in operational costs or living expenses.
• Poor financial planning: Lack of budgeting or inadequate financial management.
• Reduced income: A decrease in income, such as from loss of employment, reduced business profits or other factors.
• Unexpected events: Medical emergencies, natural disasters or unforeseen legal issues.

Insolvency vs. bankruptcy

The terms insolvency and bankruptcy are sometimes used interchangeably. However, while both situations stem directly from financial problems, they have little else in common.

Bankruptcy is a legal status involving court processes under U.S. Code: Title 11, better known as the Bankruptcy Code. It often requires the involvement of lawyers and may result in court orders, judgments or decrees.

On the other hand, insolvency is purely a financial condition that occurs when individuals or businesses have insufficient cash or cash equivalents to pay expenses or debts.

If you’re unable to overcome insolvency, bankruptcy may be a solution for managing and eliminating overwhelming debts. Common types of bankruptcy resulting from insolvency include Chapter 7 (total liquidation), Chapter 11 (reorganization) or Chapter 13 (debt readjustment).

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 offer guidance on effective money and debt management strategies. Often, these sessions result in a personalized debt management plan to help you navigate financial challenges.

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

Debt settlement/debt relief

Debt settlement involves negotiating with creditors to reduce the debt. This approach may include reducing the total debt if you agree to pay a lump sum.

You can settle the debt yourself or pay a fee to a debt settlement company to help you take care of the process.

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.

It’s also important to note that not all debt settlement agencies are reputable. Avoid potential scams by doing your homework before choosing a company.

Asset liquidation

Asset liquidation involves selling your assets to quickly generate the cash needed to settle debts with creditors. Whether it’s your home, business equipment, or even a collection of valuable baseball cards, liquidation may help you rapidly resolve your debt.

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.

However, you may be able to invoke an insolvency exclusion by proving to the IRS that you were insolvent at the time the debt was forgiven. Here’s how:

1. Analyze the fair market value of your assets against your liabilities. Calculate the market value of your assets — such as your house, car, furniture, retirement accounts or jewelry — and compare it to your liabilities, including mortgages, home equity loans, credit card debt and student loans. If your liabilities exceed 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, especially if it leads to bankruptcy. However, you can move on after insolvency and keep it from happening again.

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.

Next steps

Remember, insolvency doesn’t have to define your financial future. Instead, you can use this experience as a stepping stone to build better financial habits. Start by creating a realistic budget that aligns with your income and expenses, and avoid taking out loans you may not be able to repay.

Most importantly, don’t beat yourself up over past financial mistakes. Many people have overcome insolvency and gone on to achieve financial stability. With determination, smart choices and a willingness to learn, you can too.