As we all know by now, when an individual owes a debt to another person or entity and the debt is forgiven, the canceled debt may be taxable. In the past, this general rule has applied to debt forgiveness related to a short sale. In 2007, Congress passed the Mortgage Debt Forgiveness Act (“MDFA”). The MDFA allowed homeowners to exclude debt cancellation income; however, the MDFA was passed with a sunset provision that automatically cancels the Act on January 1, 2013. It is foreseeable that the MDFA could be extended in 2013, but there is uncertainty what that extension will look like. There is good news for most clients you work with that are considering a short sale. There may be a way to avoid the tax consequences without the uncertainty, the Insolvency Exception.
HOW THE INSOLVENCY EXCEPTION WORKS
Under the insolvency exception, if the cancellation of the debt or debt forgiveness (i.e., short sale) occurs while the debtor/taxpayer is insolvent, then the taxpayer may reduce the amount of the cancelled debt from their gross income. See 28 U.S.C. § 108(a)(1)(B). While the insolvency exception can be complicated it generally works as follows:
Client owes $200,000 on their mortgage. The FMV of the home is $100,000. The homeowner has no other debts or assets. At the time of the short sale, the client is forgiven of $100,000. Because the total assets belonging to the client is $100,000 (i.e., the FMV of the house) and the client has an outstanding liability or debt in the amount of $200,000 (i.e., the mortgage on the property), the client is insolvent in the amount of $100,000. Under 28 U.S.C. § 108(a)(1)(B), the client may file a form 982 (found here http://www.irs.gov/pub/irs-pdf/f982.pdf) with their income tax return and exclude up to $100,000 of cancellation of debt income from their gross income. That means that in this case, the client would have no taxable income from the short sale.
While we have described general rules above, it is always important to discuss individual application to a specific situation. One fact can change the outcome of any situation. Articles describing general rules are good for informational purposes, but they do not take the place of professional advice from an attorney or CPA.
Jason Wells, Esq. & Chris Niederhauser, Esq., partners at the Wells Realty & Law Groups, are here to answer any of your real estate questions. Call us today at 480.428.3290 to schedule a FREE CONSULTATION to evaluate your short sale or foreclosure candidacy.