The Worm In The Debt Forgiveness Offer

Letters in the client’s mailbox superficially offer great news:  the junior mortgage will be forgiven!

That good news just adds on a new facet to our job description:  spotting possible  tax consequences and alternatives for our clients by reason of  tax on cancellation of debt.

As  the National Mortgage Settlement  gains momentum, we can expect to encounter this more often.

The topic is huge and the taxes nominally involved may swamp all the other unsecured debt that a prospective client has.

All I can do here is outline the issues and the resources for further study.  Master this area and your clients will think you walk on water.

In the beginning

We start with the principle that when debt is forgiven, the amount forgiven is treated for tax purposes as if it was received in cash by the debtor.  It is included in income and subject to tax 

IRC 108 lists the statutory exceptions to that rule, including our stock in trade: bankruptcy.  Debts forgiven in bankruptcy do not cause the inclusion of  the forgiven debt in income.

Foreclosure

Your clients may be surprised or dismayed to learn that a foreclosure may result  not only in the loss of the property but in a tax bill to boot. Where the value of real estate has fallen dramatically, a foreclosure not involving bankruptcy may generate a 1099-C  (the statement of the amount of cancelled debt) for the difference between the loan balance and the deemed fair market value of the property.  Six digit numbers are easily possible.

Therein is one of the stellar qualities of a bankruptcy solution to debt.  If the individual’s personal liability for a junior mortgage loan is discharged in bankruptcy, should the debt be subject to a foreclosure in the future, no tax consequences ensue.  It is also one of the reasons that I have taken clients with no significant, existing debt, into bankruptcy before the inevitable foreclosure.  The bankruptcy discharge will insulate them from tax on the difference between the mortgage balance and the fair market value of the property.

Qualified principal residence safe harbor

When the foreclosure crisis started, perhaps  the  only useful Congressional response was creating an exclusion from inclusion in taxable income for qualified debt on a taxpayer’s principal residence.

The exclusion only applies to debt used to buy, build or substantially improve the home.    So, if the debt is a refinance, your client may not qualify. Further, the provision is set to expire at the end of 2012.

Insolvency

Another exception to the rule that cancelled debt is included in gross income for tax purposes is insolvency.  If the debtor is insolvent, the cancelled debt is not included.  The non obvious trap here is that retirement assets are included in the balance sheet test.  So, your client may think he has nothing, but if there is a fat 401(k), they may not be as broke as they think they are.  The worksheet for calculating insolvency for these purposes is found in IRS publication 4681.

So, if you have the opportunity to counsel a homeowner who has received an announcement that their line of credit loan is being cancelled, point out the issues to them.  Look at the alternatives and be prepared to send them to sophisticated tax advisors who can assess the tax consequences of the disappearing debt.

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