The Mortgage Debt Relief Act of 2007 has saved countless taxpayers from devastating IRS tax bills for "forgiven debt" resulting from lenders forgiveness of deficiencies from foreclosures, deeds in lieu of foreclosure and short sales. But the Act has expired for any transactions that closed (or occurred) beginning January 1, 2014. So now what can a financially distressed taxpayer do when addressing a foreclosure, deed in lieu of foreclosure or short sale?
Will the Act get a third breath of renewal?
The Act was to have expired December 31, 2012. In the omnibus tax bill passed in mid January 2013 it was revived until December 31, 2013. But the pending legislation to revive the bill once again (there are two versions out there, one with a one year revival and one with a two year revival) may not see action until election time according to my meeting with one of its sponsors last week. That is a long time to wait for a retroactive application of a tax law and makes for difficult tax planning and decisions on how to avoid the tax bite of that forgiven debt.
Alternatives to having to rely on the Mortgage Debt Relief Act -
There are essentially two ways of not having an income tax liability when dealing with forgiven debt. The first is the "Asset Insolvency Test". This is a mathematical exercise that requires that the taxpayer make up a list as of the date (immediately prior to the date) of the forgiveness event. The list is a total of all liabilities including the debt being compromised, including credit card, student loans, other mortgages, unsecured debt, car loans, etc. That is the liability list. The second list is the gross asset list. Gross assets are the values of cash, bank accounts, stocks and bonds, real estate (without the mortgages), cars, jewelry, furnishings, etc. Realize this test has nothing to do with your cash flow and ability to pay your bills - it is all about assets.
Take the negative number you get from the liability list and add it to the positive number from the gross asset list. If the resulting number is negative, then you can deduct that negative number from the amount of the forgiven debt, thereby reducing or completely avoiding any portion of the forgiven debt and thus any tax liability.
I wrote about this test and give an example in my article, SHORT SELLER MUST STILL DECLARE INCOME ON SALE. See it for more detailed examples and citations to the IRS Code.
The other way to avoid the issue of foregiven debt is more problematic and I suspect that many may take this route with the uncertainty with the retroactive renewal of the Act. The problem with this secondary solution is that if the Act does not get renewed, and of the numbers on the "Asset Insolvency Test" just don't work enough to reduce tax liability, you have to implement this solution BEFORE you undertake the short sale, foreclosure or deed in lieu of foreclosure. This solution is a bankrutpcy filing, typically under Chapter 7 (elimination of debt) but sometimes under Chapter 13 (restructuring).
The essence of the bankruptcy filing is to avoid the foregiveness of debt. To avoid the forgiveness of debt you have to have no debt to forgive. So by example if you did a short sale and the short sale agreement with the bank says they are waiving the deficiency on the unpaid balance, then you have at closing of the short sale, forgiven debt. The obligation is converted to forgiven debt. You cannot discharge forgiven debt in bankruptcy. On the otherhand, if you file for bankruptcy before the short sale, then the promissory note obligation is (typically) eliminated. Thus you have no debt to be forgiven and no tax liability. Timing is most important in determining if and when to file a bankruptcy and of course whether you indeed qualify to file a bankruptcy and if so, what type. A knowlegeable bankruptcty attorney must be consulted.
So even if the Mortgage Debt Relief Act of 2007 does not get another year or two of effect, all is not lost for those with problematic foregiven debt issues. Speak with an experienced CPA or real estate or tax attorney on what your tax exposure may be and then work to address the best means for you to reduce or eliminate the potential burden.
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© 2014 Richard P Zaretsky, Esq.
Be sure to contact your own attorney for your state laws, and always consult your own attorney on any legal decision you need to make. This article is for information purposes and is not specific advice to any one reader.
Richard Zaretsky, Esq.
RICHARD P. ZARETSKY P.A. ATTORNEYS AT LAW
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