- Former homeowners with forgiven debt can avoid tax liability
- You must be 'insolvent' to eliminate the taxable income
- The IRS's insolvency worksheet will help you calculate any taxable income from forgiven debt
How Homeowners Issued 1099-Cs Can Avoid Tax Liability
The Mortgage Forgiveness Debt Relief Act was extended through Jan. 1, 2014 as part of H.R. 8, the legislation Congress sent to the President on Jan. 2 2013 to avoid the "fiscal cliff." H.R. 8 also includes a deduction for Mortgage Insurance Premiums for taxpayers making less than $110,000 for the year 2013, and was made retroactive to cover 2012.
The Mortgage Forgiveness Debt Relief Act is scheduled to expire as we ring-in the New Year to 2013. The end of this law may have tremendous tax consequences for homeowners who have lenders forgive the deficiency balances for short sales, foreclosures, and deeds in lieu of foreclosure. However, a similar rule called insolvency exclusion may prevent former homeowners from getting socked with a large tax bill following a debt forgiveness.
Why did Congress write and then-President Bush sign the Mortgage Forgiveness Debt Relief Act? Under today’s tax law, the IRS must treat any forgiveness of a debt from a financial institution as "income." Financial institutions that forgive a $600 or greater debt must issue a 1099C and disclose this to the IRS and the borrower. The Mortgage Forgiveness Debt Relief Act gave homeowners who suffered the effects of a short sale or foreclosure two means to exclude the potential tax liability of the cancelled debt.
Under the Mortgage Forgiveness Debt Relief Act, borrowers were allowed to exclude debt forgiven on their principal residence if the balance of the loan was $2 million or less. The loan balance forgiven must have been used to buy, build, or improve a principal home and secured by the property. Vacation and investment homes were not subject to the Mortgage Forgiveness Debt Relief Act. See the Bills.com article The Mortgage Forgiveness Debt Relief Act to learn more.
Now that the Mortgage Forgiveness Debt Relief Act is about to expire, will homeowners who experience a forgiven debt on a short sale, foreclosure, or deed-in-lieu-of-foreclosure be stuck with large tax bills? Not necessarily, for two reasons:
- Congress and the President could extend the law relatively easily
- The homeowner may have been insolvent at the moment of debt cancellation
Let’s look at the insolvency exclusion to the "debt + forgiven = taxable income" rule. You will see in a moment why we used a math equation metaphor to explain the rule.
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According to IRS rules, a person is insolvent if all of his or her liabilities exceeded the fair-market value (FMV) of his or her assets. Assets include the value of everything the taxpayer owns. Liabilities are everything he or she owes. The table Assets & Liabilities below explains.
|Assets & Liabilities for Insolvency Exclusion|
|Any collateral for debt||Entire amount of recourse debt|
|Exempt assets such as interest in a pension plan or retirement accounts||Amount of nonrecourse debt not in excess of the FMV of the property that secured the debt|
See Publication 4681’s Insolvency Workseet to see a more complete list of assets and liabilities the IRS allows in these calculations.
To illustrate this concept, the IRS offers two hypothetical examples in chapter 1 of its Publication 4681. "Greg" is forgiven on $5,000 of debt, and receives a Form 1099-C from his lender showing canceled debt of $5,000 in box 2. Greg’s total liabilities immediately before the cancellation were $15,000, and the FMV of his assets were $7,000. This means that in the moment before the forgiveness, Greg was insolvent by $8,000.
In the IRS’s second hypothetical example, Greg’s total liabilities in the moment before the cancellation were $10,000. The FMV of Greg’s assets were $7,000. Here, Greg is insolvent to the extent of $3,000. “Because the amount of the canceled debt was more than the amount by which Greg was insolvent, Greg can exclude only $3,000 of the $5,000 canceled debt from income under the insolvency exclusion. Greg checks the box on line 1b of Form 982 and includes $3,000 on line 2. Also, Greg completes Part II to reduce his tax attributes as explained under Reduction of Tax Attributes, later. Additionally, Greg must include $2,000 of canceled debt on line 21 of his Form 1040 (unless another exclusion applies),” according to the IRS.
Here’s the math:
|IRS Publication 4681 Insolvency Exclusion Examples|
|Example 1||Example 2|
|Amount Cancelled / Forgiven||$5,000||$5,000|
|Amount of Exclusion||$5,000||$3,000|
|Form 1040 Line 21||$0||$2,000|
|* The moment before cancellation or forgiveness|
Exclusion Examples. Source: IRS & Bills.com
More on Cancellation of Debt Income
If you receive a 1099C, keep it with your other tax documents. Give the 1099C to your tax preparer plus information regarding your total liabilities and the fair-market value of your assets as they were immediately before the cancellation. Note that Publication 4681 covers the current tax year, where the Mortgage Forgiveness Debt Relief Act still applies. If Congress and the President extend the Mortgage Forgiveness Debt Relief Act, you will have the option to use either the Qualified Principal Residence Indebtedness exemption, or the insolvency exclusion discussed above.
If, however, the Qualified Principal Residence Indebtedness exemption is not extended beyond the end of 2012, homeowners will have only the insolvency exclusion available to reduce or eliminate their forgiven tax liability.