As borrowers continue to grapple with upside-down loans and short sales and foreclosures continue to climb, the risk of debt forgiveness tax becomes more important, especially for investors who do not have the personal residence exclusion from Federal taxes on forgiven debt.  “Debt Forgiveness” occurs when the lender doesn’t get paid all that they are owed and they are not going to pursue you for any unpaid balance.  Although the risk of a judgment on the unpaid balance goes away, you can be taxed on the amount of forgiven debt as if it were income you had earned,. This is often called “Phantom Income” because you never really saw it but you are still affected by it.  As I discussed in prior Blogs, the Federal government has relief from this tax on personal residences through 2012. California has no relief.  Luckily, both have an “insolvency Exclusion” that may apply and which can enable a debtor to otherwise avoid being driven into Bankruptcy. Since Bankruptcy has far greater potential negative consequences than a short sale or even a foreclosure, the possibility of avoiding these taxes without filing Bankruptcy is important. Here’s how the Insolvency exclusion works.

As set forth in full on IRS Publication 4681 “Cancelled Debts, Foreclosures, Repossessions, and Abandonments” http://www.irs.gov/pub/irs-pdf/p4681.pdf, Insolvency is determined by first listing the fair market value of all of your liabilities immediately before the debt forgiveness event (short sale or foreclosure). Next you list the fair market value of all of your assets at the same point in time.  Next, you subtract your assets from your liabilities. If the result is zero or less, ie: your liabilities exceed your assets, then you are insolvent.  Page 6 of Publication 4681 has the actual worksheet you can use to make this calculation.  Once the insolvency is determined, you report this on your tax return through the use of IRS Form 982 http://www.irs.gov/pub/irs-pdf/f982.pdf

California appears to draw it’s insolvency determination from the IRS Form 982. California’s taxing agency is the Franchise Tax Board (“FTB”). As stated in the FTB Tax News dated February, 2010 http://www.ftb.ca.gov/professionals/taxnews/2010/February/Article_8.shtml “if the loan is recourse indebtedness and the debtor incurs cancellation of indebtedness income (CODI), IRC Section 108 provides certain exceptions in recognition of that income. One of the exceptions applies where the taxpayer was insolvent (total liabilities exceed total assets) when the CODI was realized. The exclusion only applies up to the amount of insolvency, i.e., to the extent the liabilities exceed the FMV of the assets”. However, California law does not conform to all of the provisions currently available in IRC Section 108.

The key is this:  If you are an upside-down borrower facing a debt forgiveness tax as a result of a short sale or foreclosure, you may be liable for debt forgiveness tax and may queslify for the insolvency exclusion. Be certain to get tax advice from a qualified professional who can look at your specific situation and advise you on how these rules apply to you.  This Article is solely intended to give you an introduction to what might be available for you but you should not rely on it to apply to your financial circumstances.

If you have specific questions about your liability, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com.  Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/.

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