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In order to understand all this a little better, could you point me to something that explains "insolvency".

It's probably explained a bit in the IRS publication I pointed you to.

But, it's pretty simple when you get down to it. Add up his assets - everything he owns. Add up his liabilities - his debts - what he owes. If the liabilities are bigger than the assets, he's insolvent.

For tax purposes and cancellation of debt income, you do that calculation just BEFORE the debt was canceled. So you include the canceled debt in the liabilities.

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