A client of mine recently contacted me with respect to a Notice from the Internal Revenue Service. In early 2009, my client's condominium investment unit, in a poorly run building in a far from safe part of Boston, was foreclosed upon. My client had stopped paying on his mortgage, and at the time of the foreclosure sale, the mortgage balance was $305,000, with the unit having a market value of less than $200,000. My client thought he was safe, because he was not being "dunned" any more by the lender. The investment unit, which had been a constant headache and cause for concern, was now gone, and forgotten.
You can imagine my client's dismay when the IRS contacted him and told him that he owed substantial taxes, interest and penalties arising from the 2009 foreclosure sale. The amount of taxes in question arose from "debt forgiveness" which resulted when the lender received more than $100,000 less from the foreclosure that the outstanding obligation on the mortgage loan. The Mortgage Forgiveness Debt Act of 2007 "MFDA"[undated December 11, 2008, and then after] permits Borrowers not to recognize income when their personal residence is foreclosed upon and proceeds realized which are less than the amount owed under the mortgage note.
Investment property does not, however, fall under the purview of the MFDA. Accordingly, all of the forgiveness my client received from the lender was now classified as income. Worse than that, even if my client files for bankruptcy protection, taxes are not an item which can be discharged.
Fortunately for me, I work closely with an accountant who is knowledgeable in this area, and my client's story ended on a happier note. There is also a provision in the Internal Revenue Code which provides that if the debt forgiveness takes place when the taxpayer is "insolvent", the debt forgiveness does not need to be recognized as income. My accountant took a look at my client's financial situation, and made the determination that my client was "insolvent" at the time of the forgiveness. As you must understand, every person's financial situation is different, and I could not possibly comment on any person's ability to avail himself or herself of this provision. The only person who can perform this exercise is the person's financial advisor, lawyer or accountant.
What I am saying, however, is that if you, or a friend or customer, is confronted by the IRS for claims of debt forgiveness income after a foreclosure of investment property, the "insolvency" defense may be a good place to start to obtain relief. Most people who permit a mortgage loan to slide to the point of foreclosure probably have other financial problems as well. If that is the case, the "insolvency" claim may prove to be an important option to consider.
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