Normally, when debt is forgiven, the cancelled debt is considered taxable income for federal income tax purposes for the person whose debt is forgiven. This could occur in the case of a foreclosure or the short sale of a home. The Mortgage Debt Relief Act of 2007, which was extended until the end of 2012, provided relief from that tax liability in the case of a taxpayer’s principal residence.
Aside from the Mortgage Debt Relief Act, you could avoid having to pay income tax on cancelled debt by filing for bankruptcy. But you could also be relieved of the tax liability if you were insolvent immediately before the debt was forgiven. This insolvency is for federal income tax purposes and means that your total liabilities are greater than the fair market value of all your assets.
When mortgage debt is forgiven through a debt restructuring, short sale, or foreclosure, the bank or financial institution will send you and the IRS a Form 1099-C, Cancellation of Debt. The amount of debt discharged is reported in box 2. If you believe that you were insolvent, you would have to file Form 982 to claim the insolvency exception. Form 982 is submitted along with your annual income tax return.
As pointed out by George Sanz in a post on the Bankrate website, in determining insolvency for tax purposes you may have to take into account certain assets such as retirement accounts that could be exempt in a bankruptcy proceeding.
Your assets for purposes of determining insolvency include all your cash and bank balances, your home, vehicles, and other tangible assets, your retirement accounts including IRAs and 401(k)s, the cash value of a life insurance policy, your investments, and your interest in a business. In IRS Publication 4681 there is a worksheet to help you calculate the amount to which you are insolvent.
The amount of cancelled debt you can exclude from taxable income is limited to the amount by which you were insolvent. For example, if your total liabilities immediately before the debt cancellation were $150,000 and the fair market value of all your assets was $80,000, you were insolvent to the extent of $70,000. If you have cancelled debt of $50,000 you could exclude the entire amount of the cancelled debt from your taxable income. But if the cancelled debt was $90,000 you could only exclude up to $70,000, the extent to which you were insolvent.
When you do not have to include cancelled debt in your taxable income because you are insolvent, you are required to reduce what the IRS refers to as “tax attributes”. There are several types of tax attributes that would be reduced, depending on the reason the cancelled debt was excluded from your income. These include your basis in depreciable property, net operating loss carryovers, capital loss carryovers, passive activity loss and credit carryovers, and others. If you do not have any of these tax attributes, you would reduce the basis in your personal property. By reducing the basis, you would be increasing the potential taxable gain if you eventually sell or dispose of that property.
Sources:
Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), IRS
Form 1099-C, Cancellation of Debt, IRS
George Sanz, Claim insolvency, avoid tax on short sale, Bankrate
Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments, IRS
