It’s a brand new perspective for me as I counsel families with homes at risk of foreclosure. Given mortgage debt that exceeds today’s value of the property, a foreclosure will result in a 1099 for the difference between the loan balance and the current market value of the property, as selected by the creditor. Absent one of the statutory safe harbors, that dollar amount is includible in taxable income. Ouch!
Bankruptcy is one of those safe harbors.
Internal Revenue Code Section 108 provides that income from cancellation of debt is not includible in gross income if the discharge of the debt occurred in a case under Title 11. That’s been an advantage of bankruptcy over debt settlement that’s been part of our arsenal for a while. But with falling home values, I’m now seeing bankruptcies that are necessary only because of the otherwise horrific tax cost of foreclosure .
Insolvency is also a defense to inclusion of the income, but it’s insolvency under the IRS rules that includes the value of exempt property and retirement savings. I’ve seen recently several clients with multiple properties and an opinion from their tax guy that they needn’t worry, they’re insolvent. Yeah, maybe today, before the first foreclosure. Will it be the same when the last property is foreclosed?
Of course, the tax law has lots of wrinkles in application. There is no risk of COD income if there is no personal liability on the discharged debt. What about short sales? Loan modifications?
My friend Bill Purdy, mortgage lending lawyer and tax professor, is going to answer all my questions at his presentation Debt & Tax Collide on April 9th in San Jose. I’ll report back on what I learn about the inner workings of cancellation of debt income. If you’re in Northern California, join us. If not, watch for release of the program on “tape”.
Image courtesy of River Beach