Everyone who is considering a short sale of their primary residence is currently in a holding pattern waiting to see if Congress renews the Mortgage Debt Relief Act. The Mortgage Debt Relief Act enables Borrowers to avoid paying income taxes on the amount of debt that is forgiven as part of a short sale where the Borrower sells his or her primary residence for less than they owe. Currently, without an extension from Congress, this exemption from taxability will expire on December 31, 2012.
However, while the press has latched onto the expiration of this exemption from taxability as a focus of many recent news articles, the Mortgage Debt Relief Act is not the only exemption from IRS taxability of forgiven debt. There are other exemptions from the general rule that forgiven debts are generally taxable as income to the Borrower. In my practice, I see the insolvency exemption as the exemption most regularly used to exempt forgiven debt in a short sale from taxation as income.
If you are insolvent when the debt is cancelled (i.e. the lender has given you a waiver of deficiency in a short sale), some or all of the cancelled debt may not be taxable to you. You are insolvent when the total of ALL of your debts (including the debt on the property you sold at a short sale) are more than the fair market value of ALL of your assets (including the value of the property you sold at a short sale, and including the value of any retirement accounts - 401k, IRA, etc.).
The insolvency exemption can be used to exempt forgiven debt on a primary residence from taxation, but more importantly, can be used to exempt forgiven debt on second homes or investment properties from IRS taxation.
For most Borrowers in Florida, the value of their underwater property has fallen so significantly that the amount of the deficiency exceeds the total of all of their other assets. While the thought is certainly depressing, a Borrower's insolvency can actually be useful to give property owners a fresh start without filing for bankrupcty.
To claim this exclusion, you must attach Form 982 to your federal income tax return. To determine your eligibility for the insolvency exemption, you should speak to your accountant.
If you are insolvent, there is no need to wait for a decision from Congress to short sale your underwater property. Contact our office today for more information on how we can assist you making your ownership of underwater property a thing of the past.