I recently completed a deed in lieu of foreclosure for 2 condos. The two banks will send me a 1099 form each (forgiveness of debt) by next year. When I do my taxes next year, one of these 1099 forms froms will not be taxable because one of the condos was my residence. I intend to make other 1099 form non-taxable for the reason of insolvency.
My question is: When does IRS consider me insolvent? Is it enough for me to prove that (at the time the deed in lieu was completed) my liabilities were higher than my assets? Or do I need to file for bankruptcy in order to be considered insolvent by the IRS?
As a tax attorney in Naples Florida (ground zero, basically, for the real estate crash), I consider this issue all the time. You are correct in that what would otherwise be taxable income from the forgiveness of indebtedness / cancellation of debt (COD) is excluded from income under the The Mortgage Forgiveness Debt Relief Act, up to $1M. I assume the amount forgiven is less than this.
The IRS standard for "insolvency" is simply the amount by which your liabilities exceed your assets at the time the debt is cancelled. Valuing your property is easy in the case of cash accounts, etc (face value), and a reasonable methodology for valuing most other tangible assets will be acceptable (e.g. a home appraisal) for these purposes.
One "gotcha" in this equation are qualified retirement accounts such as IRAs and 401(k)s. Even thought these accounts are protected from creditors under common law they DO count towards the value of your assets. Another important fact (this one in your favor) is that your liabilities are calculated prior to the cancellation of the debt. As such, you get "credit", so to speak, for that amount of debt prior to the asset being liquidated (i.e. your foreclosure).
Bankruptcy under the relevant Internal Revenue Code provision (Sec. 108) is distinct from the insolvency exclusion and therefore in my view no, you would not need to file bankruptcy in order to get relief from these tax consequences.
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Ari Good, Esq. is licensed to practice law only in Florida, Illinois (inactive) and Washington, DC (inactive). Good Attorneys At Law maintains offices in Naples, Florida. The foregoing answer is for informational / educational purposes only: NOTHING IN THE FOREGOING ANSWER MAY BE INTERPRETED AS FORMING AN ATTORNEY CLIENT RELATIONSHIP NOR DOES IT CONSTITUTE TAX OR LEGAL ADVICE. Pursuant to Circular 230, nothing in the foregoing answer may be used for the purpose of avoiding penalties.
You should meet with a tax advisor to discuss this. Even if you are insolvent, the amount of forgiveness is income and may be taxable as such. Capital gains on a residence are excludable from income, loan forgiveness on your residence may not be.
This response does not create an attorney client relationship and is offered for informational purposes only. Only a lawyer fully versed on the facts and circumstances of your case can properly advise you on the case. I am licensed to practice in Minnesota, not every state. You should always consult with an attorney licensed in your area on how best to proceed.
Real Estate Attorney
I agree w/ Mr. Fossum; meet with a tax advisor. As to your "investment" property there is a good chance that you have accumulated costs and expenses and losses (you call them liabilities) that could be charged against any so-called cancellation of debt income, resulting in a "wash" or $0 taxable phantom income.