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The Mortgage Forgiveness Debt Relief Act expired December 31, 2013. The Act prevented homeowners who go through a short sale or foreclosure from being taxed on the amount of their mortgage debt that has been forgiven. (Normally, debt that has been forgiven by a lender counts as taxable income.) A short sale transaction would have had to close before Dec. 31, 2013 in order to take advantage of the Act’s tax exemption. The good news is there is still a way to avoid paying income tax on forgiven debt.
IRS “Insolvency Clause” Offers Tax-Saving Alternative
Homeowners that are panicking about potentially hefty tax bills are probably not aware that they may still qualify for tax relief via the IRS “insolvency clause”. The clause states that a seller is exempt from paying tax on any forgiven debt to the extent that they are insolvent. In other words, if the seller’s debts and liabilities exceed their assets by more than the amount of debt forgiven, they do not have to pay taxes on the forgiven debt.
Here’s an example:
A seller has a home valued at $300,000, but the mortgage debt is $400,000. We short sell the property for $300K and the bank elects to forgive the debt on the $100,000 shortfall amount. Since debt that has been forgiven counts as taxable income, the IRS would treat the $100,000 of forgiven debt as income.
MORTGAGE DEBT SALE PRICE FORGIVEN DEBT
(Taxable income)
$400,000 – $300,000 = $100,000
This is where the insolvency clause formula comes in. Begin by adding up all of your debts/liabilities in one column and all of your assets in another. For this formula, the IRS wants you to include the mortgage debt as a liability, and the fair market value of your house as an asset. Let’s say you have $600,000 in assets and $700,000 in debts/liabilities. You are insolvent by $100,000.
ASSETS LIABILITIES INSOLVENCY
$600,000 – $700,0000 = [ $100,000 ]
Since your insolvency amount of $100,000 equals the forgiven debt amount of $100,000, it’s a wash and you will not have to pay taxes on that forgiven debt. You are shielded dollar-for-dollar on the amount of forgiven debt up to your insolvency number. Let’s say you were only insolvent by $80,000. In that case, you would still have to pay income tax on the remaining $20,000 of forgiven debt.
INSOLVENCY FORIVEN DEBT TAXABLE INCOME
[ $100,000 ] – $100,000 = -0-
Richard Eastern is a Windermere broker in Bellevue, WA and co-founder of Washington Property Solutions, a short sales negotiating company. Since 2003 he has helped more than 1000 homeowners sell their homes. The company offers free attorney and CPA consultations as part of their service. A Bellevue native and a University of Washington grad, Richard is an avid sports fan and a devoted Little League and basketball coach. You can learn more about Richard here or at www.washortsales.com.
