How Insolvency Can Help You Avoid an IRS Bill

The idea of owing the IRS more money than you can afford to pay is enough to strike fear into any heart. And that’s what would have happened to thousands of California homeowners had Congress not consistently extended the Mortgage Debt Relief Act – now in force through 2016.

However, homeowners who have been struggling financially have no real needed to worry.

While the term “insolvent” is not one that most of us would like to apply to ourselves, the IRS definition of this term may be the saving grace for California homeowners whose mortgage debt far exceeds the current value of their homes.

The following is excerpted from the IRS instructions found at www.irs.gov.

We’ve included official IRS definitions as referenced and found later in their text. Notes in parentheses are ours.
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Insolvency

Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. (emphasis mine – note the date)You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account).

Liabilities include:
• The entire amount of recourse debts,
• The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt, and
• The amount of nonrecourse debt in excess of the FMV of the property subject to the nonrecourse debt to the extent nonrecourse debt in excess of the FMV of the property subject to the debt is forgiven.

You can use their Insolvency Worksheet to help calculate the extent that you were insolvent immediately before the cancellation.

This exclusion does not apply to a cancellation of debt that occurs in a title 11 bankruptcy case. It also does not apply if the debt is qualified principal residence indebtedness unless you elect to apply the insolvency exclusion instead of the qualified principal residence indebtedness exclusion.

Qualified Principal Residence Indebtedness

You can exclude canceled debt from income if it is qualified principal residence indebtedness. Qualified principal residence indebtedness is any mortgage you took out to buy, build, or substantially improve your main home. It also must be secured by your main home. Qualified principal residence indebtedness also includes any debt secured by your main home that you used to refinance a mortgage you took out to buy, build, or substantially improve your main home, but only up to the amount of the old mortgage principal just before the refinancing.

How to report the insolvency exclusion. To show that you are excluding canceled debt from income under the insolvency exclusion, attach Form 982 to your federal income tax return and check the box on line 1b. On line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately before the cancellation. You can use the Insolvency Worksheet, to help calculate the extent that you were insolvent immediately before the cancellation. You must also reduce your tax attributes in Part II of Form 982 as explained under “Reduction of Tax Attributes.”

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Remember that the insolvency exclusion applies to all forgiven debt. So if you got a reduction on a credit card account in exchange for full payment, or if a credit card company “wrote off” your debt, you’ll owe the income tax if you can’t prove insolvency.

If you think you may be eligible for tax relief under these IRS rules, please contact your tax professional for further advice.


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This site provides information about real estate, law, income taxes and credit scores as relates to borrowers in distress, short sales and similar situations. The site is designed to help users safely cope with their own needs. Information is not the same as advice — the application of law or regulations to an individual’s specific circumstances. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a lawyer, tax adviser or other specialist if you want professional assurance that our information, and your interpretation of it, is appropriate to your particular situation. The models in photographs accompanying the testimonials on this website are used for illustrative purposes and are not a personal endorsement.