‘Insolvency’ Tagged Posts

Mortgage Debt Cancellation and the Insolvency Exclusion

Considering the all the foreclosures and short sales, taxation of debt cancellation continues to be a significant issue.  There are many misconceptio...


Considering the all the foreclosures and short sales, taxation of debt cancellation continues to be a significant issue.  There are many misconceptions regarding the tax consequences and still many concerned taxpayers.  The tax consequences can be severe, so people need to make sure that they are educated on the issue.

As a general rule, debt cancellation is a taxable event. But there are many exceptions that taxpayers need to be aware of. The most common exclusion is the Mortgage Forgiveness Debt Relief Act (the “Act”).  Specifically, the Act allows a taxpayer to exclude from taxation qualified acquisition indebtedness (as defined in the Act) on a taxpayer’s principal residence.  Many homeowners qualify under the Act, but be careful if you took cash out of the property as this can often create a tax problem.

One aspect of the Act that should not be overlooked is the fact that it is set to expire at the end of 2012.  I continually see people who are concerned about being upside down on their homes and currently would qualify for the tax exclusion under the Act.  But for various reasons (including moral and ethical concerns), they reluctantly continue to make their mortgage payments.  I can only hope that these people do not face a job loss, divorce or any other personal life change that would force them to sell while they are still upside down. If this occurs after 2012 they may find themselves with a large tax problem that they previously could have avoided.

Taxpayers often assume that if debt cancellation relates to their primary residence they automatically do not have a taxable event.  This is certainly not always the case.  If a taxpayer took money out of the home through a cash-out refinance or through a credit line, this can create a tax issue.  This cash may have been used to pay off other debt, medical bills, or buy a new car.  In this situation, the debt would not apply under the Act so the taxpayer will need to look to other exclusions.

One exclusion that many taxpayers must turn to is the insolvency exclusion.  You are insolvent when your liabilities exceed the value of your assets on a given date. You must analyze your liabilities and assets immediately before the debt cancellation date in order to determine if you were insolvent and the amount by which you were insolvent.  Contrary to popular belief, insolvency is not based on a taxpayer’s income.

When determining insolvency, your assets would normally include the fair value of everything you own (including assets that are collateral for debt and even exempt assets that may be beyond the reach of your creditors under the law, such as retirement accounts and pension plans). Liabilities would include the amount of all recourse debts and the amount of any non-recourse debt that is not in excess of the fair value of the property that is secured by the debt. You can exclude from your income debt canceled when you are insolvent, but only up to the insolvent amount.  Make sure though that you reduce your tax attributes accordingly.

Insolvency calculations are done just before the debt cancellation date and can be difficult calculations to produce.  Consider how challenging it would be to go back a year and try to determine your bank balance and the amount in your retirement account.  In fact, the most difficult part is often determining the value of your personal belongings, such as clothing, equipment, jewelry, and furniture.

If you are going through a foreclosure or short sale, make sure that you consult with a qualified CPA or other tax professional in addition to an attorney.  This is especially true if you believe that the insolvency exclusion may apply to your situation.

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