AS you know, cancellation of debt income can surface from the foreclosure of your residence or any other real property. Like adding salt to an open wound, you are then faced with debt forgiveness income from the cancellation of debt on the mortgage of your property that has just been foreclosed. The bank issues a 1099C for the cancellation of debt income that typically is the difference between the fair market value and loan balance. For example, you purchased a house for $300,000, placed a downpayment of $30,000, leaving a mortgage balance of $270,000, and saw the value plummet to about $200,000. By the time of the foreclosure, you could end up with a cancellation of debt (COD) income of $70,000. Not only have you just lost your house to foreclosure, you now have to pay tax on the debt forgiven of $70,000!
As for the taxpayer who was referred to me by the lawyer, we reviewed the return and found an exception that zeroed out his COD income! Let’s discuss exceptions that we analyzed for that client.
You do not have to pay taxes on such COD income if:
1. The discharge occurs in bankruptcy.
2. The discharge occurs when you are insolvent.
3. The discharged debt is qualified real property business indebtedness or qualified farm indebtedness.
4. The discharged debt arises from the purchase of the property where the seller carried the note and is now writing it down.
5. The canceled debt would have been deductible if paid.
6. The discharged debt is a student loan and certain conditions apply.
Now, let’s talk about insolvency and how it can get you out of paying taxes on forgiven debt. Neither the Internal Revenue Code nor the applicable committee reports define when a taxpayer is insolvent. There is no statutory or even regulatory guidance to help determine which assets and liabilities are included in a solvency test. You are insolvent when your liability exceeds the fair market value of your assets.
In conclusion, an analysis of your situation before foreclosure could save you from having to pay large amounts of taxes through planning and strategy with respect to insolvency and the timing of multiple foreclosures. Consult your Enrolled Agent, CPA, or Tax Lawyer. Good luck.
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Victor Santos Sy, CPA, MBA, provides professional services in accounting and tax controversy including IRS audit defense and offers in compromise. He also advises clients on choices of entity including corporations for small businesses and LLCs for rentals. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation at 704 Mira Monte Place, Pasadena, CA 91101. The firm celebrates its 35th anniversary this year. You may email tax questions to Vic at [email protected]. You are welcome to visit our website for more than 300 tax tips at www.victorsycpa.com.