The Mortgage Forgiveness Debt Relief Act expired December 31, 2013. The Act prevented homeowners who go through a short sale or foreclosure from being taxed on the amount of their mortgage debt that has been forgiven. the debt that is forgiven is normally considered taxable income. The good news is there is still a way to avoid paying income tax on forgiven debt.
Many Homeowners are not aware that they may still qualify for tax relief via the IRS “insolvency clause”. The clause states that a seller is exempt from paying tax on any forgiven debt to the extent that they are insolvent.
What does it mean to be insolvent?
Insolvent is when the borrower’s debts and liabilities exceed their assets by more than the amount of debt forgiven. In this case the borrower would not have to pay taxes on the forgiven debt.
How to calculate insolvency:
Add up all of your debts/liabilities in one column and all of your assets in another.the IRS wants you to include the mortgage debt as a liability, and the fair market value of your house as an asset. Let’s say you have $500,000 in assets and $600,000 in debts/liabilities. You are insolvent by $100,000.
ASSETS LIABILITIES INSOLVENCY
$500,000 – $600,0000 = [ $100,000 ]
Since your insolvency amount of $100,000 equals the forgiven debt amount of $100,000, it will be considered even and you will not have to pay taxes on that forgiven debt.
Likewise, if let’s say you were only insolvent by $80,000. In that case, you would still have to pay income tax on the remaining $20,000 of forgiven debt.
If you have any questions of this law please contact or feel free to comment below.