Central District Consumer Bankruptcy Attorney's Association

Cathy Moran put up this article on Bankruptcy Mastery today. Thought it
would be of interest to the group in light of the forgiveness of second
mortgage issues we've been seeing.
Letters in the clients mailbox superficially offer great news: thejunior
mortgage will be forgiven!
That good news just adds on a new facet to our job description: spotting
possible tax consequences and alternatives for our clients by reason of
tax on cancellation of debt.
As the National Mortgage Settlement gains momentum, we can expect to
encounter this more often.
The topic is huge and the taxes nominally involved may swamp all the other
unsecured debt that a prospective client has.
All I can do here is outline the issues and the resources for further
study. Master this area and your clients will think you walk on water.
*In the beginning*
We start with the principle that when debt is forgiven, the amount forgiven
is treated for tax purposes as if it was received in cash by the debtor.
It is included in income and subject to tax
IRC 108 lists the statutory exceptions to that rule, including our stock in
trade: bankruptcy. Debts forgiven in bankruptcy do not cause the inclusion
of the forgiven debt in income.
*Foreclosure*
Your clients may be surprised or dismayed to learn that a foreclosure may
result not only in the loss of the property but in a tax bill to boot.
Where the value of real estate has fallen dramatically, a foreclosure not
involving bankruptcy may generate a 1099-C (the statement of the amount of
cancelled debt) for the difference between the loan balance and the deemed
fair market value of the property. Six digit numbers are easily possible.
Therein is one of the stellar qualities of a bankruptcy solution to debt.
If the individuals personal liability for a junior mortgage loan is
discharged in bankruptcy, should the debt be subject to a foreclosure in
the future, no tax consequences ensue. It is also one of the reasons that
I have taken clients with no significant, existing debt, into bankruptcy
before the inevitable foreclosure. The bankruptcy discharge will insulate
them from tax on the difference between the mortgage balance and the fair
market value of the property.
*Qualified principal residence safe harbor*
When the foreclosure crisis started, perhaps the only useful
Congressional response was creating an exclusion from inclusion in taxable
income for qualified debt on a taxpayers principal residence.
The exclusion only applies to debt used to buy, build or substantially
improve the home. So, if the debt is a refinance, your client may not
qualify. Further, the provision is set to expire at the end of 2012.
*Insolvency*
Another exception to the rule that cancelled debt is included in gross
income for tax purposes is insolvency. If the debtor is insolvent, the
cancelled debt is not included. The non obvious trap here is that
retirement assets are included in the balance sheet test. So, your client
may think he has nothing, but if there is a fat 401(k), they may not be as
broke as they think they are. The worksheet for calculating insolvency for
these purposes is found in IRS publication 4681.
So, if you have the opportunity to counsel a homeowner who has received an
announcement that their line of credit loan is being cancelled, point out
the issues to them. Look at the alternatives and be prepared to send them
to sophisticated tax advisors who can assess the tax consequences of the
disappearing debt.

The post was migrated from Yahoo.