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Insolvency + Tax Season = Good News?

posted by Jason Kilborn

After seeing yet another prominent news article grousing about the tax consequences of short sales and other forms of mortgage relief, I thought I'd pass along a discovery I made a few years back that seems to be ignored over and over in the popular press. Bottom line: the "income" from cancellation of debt (e.g., from a mortgage modification) is often NOT taxable to the debtor.

Yes, the specific tax exemption for this kind of "income" expired last year.  But there is another, more widely applicable exclusion. IRS Pub. 4681 explains the tax consequences of many kinds of "cancellation of debt (COD) income." The focus is on exclusions for COD income incident to mortgage modifications and formal Title 11 bankruptcy cases, but it also discusses another lesser-known exclusion: the "insolvency" exclusion. If the debtor was balance-sheet insolvent (total debt in excess of FMV of all assets, including secured collateral and seizure-exempt assets) both before and after the cancellation of debt, the ordinary income from the canceled debt is excluded from taxable income to the extent of the insolvency.

So if a lender forgives $50,000 of debt in a mortgage modification (or other workout), the debtor would ordinarily recognize $50,000 in ordinary "COD" income and owe a big chunk of marginal-rate tax. But if the debtor still has other remaining debts at least equal to the FMV of all of his/her remaining assets, the cancelled debt is not taxable, as it is entirely offset by the pre-COD insolvency. If the debtor's assets exceed the value of his/her remaining debts by $30,000, that $30,000 is solvency created by the fogiveness; that's real value that the IRS will tax as ordinary income. But $20,000 of the COD income is excluded from ordinary income and not taxed. My bet is that many (if not most) people who get a major mortgage modification remain insolvent, at least barely and at least technically, following the modification, reducing or eliminating taxable income from the forgiveness. Of course, if the forgiveness is in the 6-figure range, that might well produce post-forgiveness solvency to be taxed, but the exclusion is still a major boon for all kinds of debtors who receive workouts with partial forgivenss of student loans, mortgages, taxes, etc.

The problem, as Bryan Camp of Texas Tech Law School points out in this great article, is procedural. The taxpayer, or her/his accountant, has to know about and claim this exclusion from income, especially if the debtor receives a 1099-C from the lender, reporting the COD income to the IRS. H&R Block and other mainstream tax preparers will seldom consider whether the insolvency exclusion applies (based on what I've often heard from bankrutpcy lawyers and others about tax preparer treatment of this kind of transaction). So this tax law wrinkle might well not solve all of the problem described in the NYT article linked above, but it ought not to be overlooked by debtors and their lawyers.


This is true and I am glad somebody pointed this out. It's also true that the price of a personal bankruptcy filing is quite small in relation to the benefit - including the ability to get out from under credit card bills - and thus I see no reason for any change in law in this context. The supposed harms are extremely improbable and easily avoided.

The problem is that people who just went through a foreclosure (a) won't know how big the deficiency is until the bank sells the property, (b) won't know how insolvent they'll be as of the moment the debt is cancelled, (c) probably need to hire an accountant to run through the IRS COD insolvency worksheet when the COD "income" comes in, and (d) have to include among their assets in the IRS insolvency calculation retirement funds that they could have exempted in a bankruptcy (this is a major consideration for Boomers nearing retirement). When people come to see me after a foreclosure, I tell them that they might be rolling the dice on the insolvency exception being available to them when the debt is cancelled (or that Congress will restore the QPRI exclusion). If they're wrong, they're going to have taxable COD income that can't be discharged in a bankruptcy for at least another 3+ years, whereas they could have avoided all doubt by filing prior to getting 1099'd. Coincidentally, I just posted two blogs on my website on this very issue:



Also, debt forgiveness income is only taxable to the extent it is recoverable. In CA, a loss on a purchase money mortgage is non-recourse, and therefore not taxable. A loss after 2012 on any amount not attributable to cash-out in a refi, is also non-recourse in CA, and therefore not taxable.

Wonderful. Forbes touted the same thing a month ago. If it's such a great solution, explain the impact on an over-55 year old worker with no assets except for his meager qualified retirement savings accounts. He will be wiped out to the tune of the "solvency" mirage the savings create. The worker will have no chance of making up the loss within his remaining working years. He will have a shopping cart in his future, as I do at 62, for no good reason.

If you really want to help us - take this post down. Call your Congressmen and Senators instead. Call Elizabeth Warren. Work with AARP, the NAR, the State AGs to support immediate extension of relief from taxable forgiveness of mortgage debt income.

By the way, take a look at the very recent Rev Procs. You'll see that Treasury is finding solutions for special Business entities.

I'd like to add a PS thank-you to Mr Soucy. To me, he is a voice of reason here. My take on Mr Kilborn's article is that it is more of a fiscal policy piece in advance of tax reform that obscurs the cruel reality of current law as enforced against wage earners whose only asset is retirement savings and only debt is an underwater mortgage. If so, does his fiscal policy stance make sense given disparity of impact on the state level, which in turn may trigger disparate impact at the federal level. (Not to mention the advantages of business owners over individuals).

As all of you know, we non-lawyers who have struggled to remain "responsible borrowers" all these years since the crash, often look to this website for explanations and conversation about possible solutions that are not publicly aired elsewhere.

Thank-you everyone for this site.

The situation in which many of us now find ourselves is desperate. Mr Kilborn doesn't seem to get that. Mr Soucy's 2 blog posts, hyperlinked above, are precisely the plain language information that we need now. I know that this is not intended to be such a forum, but where else can we go?

I wish you would take this opportunity to discuss some of his ideas so that we may eavesdrop.

I second Mr. Soucy's position. People who have just been compelled to give up their house are rarely in a position to prove insolvency to the IRS.

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