The Mystery of income you can't spend - but do you have to declare it?

When DON'T you have to report forgiven debt (from a short sale, deed in lieu or foreclosure with release from the lender) as income?

One of the biggest issues that potential short sellers and those in foreclosure ask me is whether they have to get a 1099 for any forgiven debt from their lender.  Without a single exception so far, every debtor (borrower) has assumed that if they can avoid a report from their lender that they are being forgiven a portion of the mortgage debt, they will not have to report any income nor pay any income tax on that forgiven debt.

While it is true that a lender need not report cancellation of debt (see 1099 Reporting - It's the Law), whether or not a lender reports forgiven or canceled debt is not the trigger for the obligation of the taxpayer to include that forgiven debt on his or her income tax return in the year the debt was forgiven.

A taxpayer has two opportunities to avoid the inclusion of the forgiven debt and thus the payment of income tax on that forgiven debt:

            1.  The 2007 Mortgage Forgiveness Debt Relief Act provides non-recognition of the income otherwise recognized as includable in income of the taxpayer for forgiven or cancelled debt.  It is only available for the amount of the original mortgage shortage after a sale on a principal residence - which is a home that is the primary home of the taxpayer for the previous 2 years prior to the short sale or debt forgiveness.

            2.  Non-recognition of income can also be achieved when immediately before the short sale (and forgiveness of the debt), the taxpayer is "insolvent".  This is an interesting definition and there are several articles and court cases on how insolvency is measured, what assets should be included and what liabilities included in the calculation.  Generally,

IRC Sec. 108(a)(1)(B) provides that gross income does not include any amount which would be includable in gross income by reason of the discharge of indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent.  Although that provision of the IRC may exclude from gross income the gain from a discharge of indebtedness for taxpayers that are insolvent, IRC Sec. 108(a)(3) limits the excludable portion to the amount by which the taxpayer is insolvent. For example, if a taxpayer owns assets with a fair market value of $100,000 and has liabilities of $125,000, only $25,000 (the amount by which he is insolvent) can be excluded if the liabilities were forgiven.  Therefore, the calculation of insolvency becomes very important.

Anyone contemplating a foreclosure, short sale, deed in lieu of foreclosure, or bankruptcy needs to become familiar with this situation! 

There is more to understand.  According to Michael Lampert, a Florida Board Certified Tax Attorney, a taxpayer should properly report that the forgiveness income was received (and this generally is limited to loans provided by persons or entities in the business of making loans - but not necessarily loans amongst family members) and then submit the schedule for non-recognition of that income (on Form 982 from the IRS) with his or her annual 1040 income tax return. He says that generally, the IRS can question that schedule for 3 years from filing.  If you don't include the income or if you understate the income, then the IRS can go back 6 years before the statute of limitations runs out.  Various events can extend that time, so anyone utilizing this route must consult with a competent tax advisor, according to Mr. Lampert. 

THIS ARTICLE SHOULD NOT BE RELIED UPON FOR TAX ADVICE.  SEEK THE ADVICE OF YOUR TAX PROFESSIONAL TO DETERMINE THE CURRENT LAW AND HOW YOUR PARTICULAR SITUATION MIGHT BE AFFECTED.

Copyright 2008 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, 1655 PALM BEACH LAKES BLVD, SUITE 900, WEST PALM BEACH, FLORIDA 33401, PHONE 561 689 6660  RPZ99@Florida-Counsel.com - FLORIDA BAR BOARD CERTIFIED IN REAL ESTATE LAW - We assist Brokers and Sellers with Short Sales and Modifications and Consult with Brokers and Sellers Nationwide!  Shortsales@Florida-Counsel.com  New Website www.Florida-Counsel.com.  See our easy to find articles at TABLE OF CONTENTS - SHORT SALE AND LOAN MODIFICATION ARTICLES.