The homeowner did the right thing: faced with the threat of foreclosure, he called his tax professional in advance.
He did the right thing that nearly produced the exceedingly wrong result.
Because the tax pro asked the wrong question and got the wrong result.
The illusion of professional advice about taxation upon foreclosure almost cost my client a bundle.
Once we dispelled the illusion and got to the real law, an emergency bankruptcy filing was in order.
Cancelled debt treated as income
The standard tax rule is that debt that is forgiven, settled or cancelled triggers potentially taxable income to the person who owed a debt.
The IRS recognizes at least two exceptions to the inclusion of cancelled debt in the taxpayer’s income: insolvency and bankruptcy.
When the client decided to let his rental property go to foreclosure, he called his accountant about the tax issue.
The accountant asked him if his debts exceeded the value of his assets.
The client’s affirmative answer produced a “don’t worry” about cancellation of debt income from the accountant: “You are protected by the insolvency exception to taxation.”
Only the DIY analysis was defective.
Insolvency isn’t so simple
Trust the IRS to have a test for insolvency that isn’t the same as the usual test.
The IRS’s insolvency test in these circumstances includes retirement assets usually excluded from balance sheets.
It isn’t just the obvious assets that are included. Retirement funds, including classic pensions and disability payments are certainly not “assets” a layman can be relied on to recognize.
This client had a comfortable disability income and, had he accepted the reassurances of his tax professional, Monday’s foreclosure would have yielded a hefty tax bill.
Bankruptcy shields filer from that tax
Instead, we’ll be filing a bankruptcy case, since discharge in a case under Title 11 (bankruptcy) is the other, often invoked exception to inclusion of forgiven debt in income.
The discharge in bankruptcy provision only works if the bankruptcy filing occurs before the foreclosure or short sale. There’s no retroactive application of the bankruptcy king’s X.
Had my client relied on the accountant’s call and let the foreclosure proceed before filing bankruptcy, the tax would have landed on his return.
And once the personal liability for the mortgage debt is discharged in bankruptcy, it doesn’t matter how much time elapses before the eventual foreclosure or sale. The subsequent foreclosure doesn’t forgive any debt: the borrower’s personal liability was forgiven long ago, by the bankruptcy.
Morale of this tale: question any tax professional who gives you a quick answer that no tax results without real analysis.
More on taxes on foreclosure.
Disputing the erroneous 1099
Image courtesy of Pixabay and PublicDomainPictures.
Peter Clapp says
It’s worth noting that under the B.Code, an individual is insolvent if his/her debts exceed assets, excluding exempt assets. 101(32)(a)(ii). I don’t know what/where the definition of “insolvency” is in the Tax Code, but I guess that it doesn’t include the same exclusion.
Ronald Suber says
You state that the bankruptcy exception applies only if the foreclosure occurs AFTER the petition is filed. The general opinion on one of my listservs is that the bankruptcy exception would apply if the foreclosure occurred within the same year as the petition was filed. Do you have a cite for the proposition that the foreclosure must occur after the petition is filed? This one threw me for a loop. Thanks.
Cathy Moran says
My tax buddies tell me the forgiveness and therefore the income occurs when the foreclosure or short sale takes place. It’s already phantom income when the debtor files his case. I’m open to citations either way.