Do I have to pay tax on my foregiven debt now that the mortgage forgiveness debt relief act has expired?

Here’s some background:  Unless there is an exemption, the Internal Revenue Service has historically treated forgiven debt as taxable income.  That means that people with forgiven debt (such as from a mortgage, credit card, or installment loan) would pay tax as if the forgiven amount were ordinary income.  To give homeowners some relief, President George W. Bush signed the Mortgage Forgiveness Debt Relief Act (MFDRA) of 2007 into law, allowing short sale sellers of their principal residence to pay no income tax as long as they submitted IRS Form 982 with their federal tax return.  The original MFDRA was good until December 31, 2009.  President Barack Obama then extended it until December 31, 2012.  Then the MFDRA was extended one more year as part of the fiscal cliff deal.  It expired on December 31, 2013.  There are currently two bills in the House of Representatives and one bill in the Senate calling for it to be extended, but as of the date of this article none of the bills are scheduled for a vote.  And as of the end of 2013, Zillow.com reported that about 10.8 million U.S. homeowners have negative equity.

So, what can a person do to avoid being hit with higher taxes after a short sale? 

Thankfully, there is another way to avoid tax on debt forgiveness that applies to many short sale sellers.  Forgiven debts do not need to be counted as taxable income if the debt was canceled in a bankruptcy case, or if the person is insolvent, or if the forgiven debt was intended as a gift.  Certain business or farm property may also qualify.

The most relevant option for short sale sellers is the insolvency exception.  It applies not just to principal residences but in some cases to those with forgiven debt from investment properties and vacation homes.

To be considered insolvent, the person’s liabilities must exceed the fair market value of their assets.  The IRS code states, “A taxpayer is insolvent when his or her total liabilities exceed his or her total assets.  The forgiven debt may be excluded as income under the ‘insolvency’ exclusion.  Normally a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent.  The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness.  If you believe you qualify for any of these exceptions, see the instructions for Form 982.” 

If the seller’s debts and liabilities exceed their assets by more than the amount of debt forgiven, then they do not have to pay income tax on the forgiven amount.  Below is an example:

Susanna’s home is worth $200,000, but her mortgage debt is $300,000.  When the house is sold for $200,000, Susanna’s lender receives $175,000 and they forgive the remaining $125,000. 

$200,000         Sale price.

- $25,000         Real estate commission and closing costs.

$175,000         Amount Susanna’s bank receives on the $300,000 balance.

$125,000         Amount of debt the bank forgives.  This is sent via a 1099-C to Susanna.

At first, Susanna panics because she fears that her income will increase by $125,000, thereby pushing her into a 33% tax bracket and increasing her tax bill by over $41,000.  However, Susanna’s accountant performs some calculations to see if she qualifies for the insolvency exemption:

$225,000         Assets ($200,000 house plus $10,000 in savings and a $15,000 car)

- $350,000       Liabilities ($300,000 mortgage plus $50,000 in credit card debt)

$125,000         Insolvency amount

Susanna’s accountant states that the insolvency of $125,000 and the 1099-C of $125,000 are a wash.  They cancel each other out.  Therefore, Susanna does not owe any tax on the canceled debt.

Let’s imagine that Susanna had an insolvency amount of $100,000 instead of $125,000.  Then she would have to pay income tax on the remaining $25,000 of forgiven debt. 

This article is not intended as tax advice.  We suggest you consult with your tax advisor prior to your short sale and then after the sale.  Your tax advisor can examine your particular situation and guide you appropriately.