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Insolvency, and Other Ways to Avoid Paying Income Tax on Forgiven Debt

Seattle Short Sales - Sunday, August 12, 2012

This article is Part 2 of a series on the tax implications of forgiven debt. Part 1 dealt with the Mortgage Debt Relief Forgiveness Act of 2007, which relieves homeowners of having to pay tax on forgiven mortgage debt. That Act expires at the end of 2012 - so Part 2 looks at other options for avoiding paying tax, and specifically at insolvency: what insolvency is, and how you can apply this clause.

It is the middle of 2012, and the Mortgage Debt Relief Forgiveness Act expires at the end of the year. Some homeowners and real estate agents might wonder if it is worth even listing a home for a short sale at this point, because they are concerned that the short sale might not close before the Act expires. They are worried that, after expiry of the Act, that any debt forgiven by the lender may be considered taxable by the IRS.

However, there are many exceptions that homeowners can use avoid paying income tax on forgiven debt that are outside of the Mortgage Debt Relief Forgiveness Act. And the exceptions don’t expire! This article lists some of those exceptions, and then focuses on the exception for “insolvency,” since that is an exception that will apply to many struggling homeowners:

Seller-financed debt:
If the person that you bought the property from actually financed your purchase, i..e. your mortgage is with the seller of your property, you are exempt from having to pay income tax on any of that forgiven debt.

Title 11 Bankruptcy:
If you are in Title 11 bankruptcy proceedings at the time that your lender forgives the debt, you are exempt from having to pay income tax on the forgiven debt. Title 11 Bankruptcy includes bankruptcy filings under Chapter 7, 11 or 13.

Insolvency:
Many people do not realize that, if they are insolvent at the time that the lender forgives the debt, they do not have to pay income tax on the forgiven debt.

Insolvency means that the your debts are greater than the fair market value of all the things that you own - including any cash in your bank accounts, as well as retirement savings (e.g. IRA accounts and 401(k) and your interest in any pension plans).

If the amount you owe (not just on your mortgage - on car loans, credit cards, everything) is more than the value of what you own, then you are insolvent. You must do this calculation for the time immediately before the debt was forgiven. If you are insolvent, the forgiven debt is not taxable - at least to the point that the forgiven debt does not make you solvent.

Here are some examples:

Example 1. Jessica is insolvent. She does not have to pay income tax on any of the forgiven debt:
Jessica owed $300,000 on her mortgage. She could not afford to keep making her mortgage payments, but her home was only valued at $210,000. Following the short sale, she paid her mortgage off for $180,000 (after closing costs). Her lender waived the $120,000 deficiency - this means that her forgiven debt was $120,000.

 Jessica was worried that she would have to pay income tax on the $120,000 - but she looked up the insolvency clause.

Immediately before the debt was forgiven, Jessica owed:
mortgage debt: $300,000
car loan: $12,500
credit cards: $8,000
student loan: $32,000
TOTAL OWED: $352,500
Immediately before the debt was forgiven, the assets Jessica owned were:
bank account: $600
home value: $210,000
car (fair market value): $15,000
household goods, clothing, etc.: $5,000
TOTAL  ASSETS OWNED: $230,600
At the time that the lender waived her deficiency, Jessica owed $352,500. Everything she owned was worth $230,600. This means that she was insolvent by $122,500.
Even the amount of the forgiven debt does not bring her back to solvency. This means that she does not have to pay income tax on any of the forgiven debt.

Example 2. Bryan is insolvent, but the amount of the forgiven debt brings him back up to solvency. He must pay income tax on part of the forgiven debt.
Bryan was self-employed, and owed $450,000 on his mortgage. The economic downturn caused his business to slow down, and his son required medical treatment. He could not longer afford to make his mortgage payments. But his home was now worth only $350,000.

His lender approved a short sale, accepting $320,000 net proceeds and waiving the $130,000 deficiency balance. Bryan still had outstanding medical bills to pay, so he looked up the insolvency clause.

Immediately before the debt was forgiven, Bryan owed:
mortgage debt: $450,000
car loan: $25,000
credit cards: $3,000
business debts: $40,000
outstanding medical bills: $60,000
TOTAL OWED: $578,000
Immediately before the debt was forgiven, the assets Bryan owned were:
bank account: $2,000
home value: $350,000
car (fair market value): 40,000
household goods, clothing, etc.: $40,000
retirement savings: $45,000
TOTAL ASSETS OWNED: $477,000

At the time that the lender waived the deficiency, Bryan owed $578,000. Everything he owned was worth $477,000. This means that he was insolvent by $101,000.

Forgiven debt is considered by IRS to be like income. Bryan’s forgiven debt of $130,000 was greater than the amount of his insolvency - so it brings him back to solvency.

The forgiven debt is exempt from income tax up to the extent of the insolvency. This means that $101,000 of the $130,000 forgiven debt is exempt from income tax. The remaining $29,000 is taxable.

To find out whether you can use Insolvency to keep from paying income tax on your forgiven debt after a short sale, download the IRS’s Insolvency Worksheet.

And don’t worry too much about the end-of-2012 deadline for the Mortgage Debt Relief Forgiveness Act - because there are many other options for avoiding paying income tax on forgiven debt.

We at Seattle Short Sales, Inc., are a team of legal, tax, and real estate professionals who have joined forces. If you would like us to take a look at your situation, to see which solution works best for you, please contact us for a no-obligation, no-fee consultation - either by phoning us at 1-800-603-3525, or by filling out the contact form at the top of this page.

If you are a homeowner, and would like to learn more about short selling your home, please go to: http://seattleshortsales.com/homeowners/

If you are a real estate agent, and would like to learn about our no-fee short sale service, please go to: http://seattleshortsales.com/agents/


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