As the prospect of simply walking away from the foreclosure battle begins to seem attractive to some, others who jumped that way are finding that the taxation authorities can be less than friendly afterwards.
This adds another dimension to an already confusing Rubik’s Cube – Federal and State laws have long regarded canceled debt as income, for the simple reason that borrowers who take advances for current spending may end up being better off even when they never settled these.
By way of example, consider the case of an un-named Colorado borrower whose husband died, and left her unable to keep on paying for the house she built. Her lender forgave the $150,000 shortfall when it took possession, now the taxman’s looking for a contribution from what it regards as income.
A Keystone, Colorado CPA I met at a convention recently told me that’s he’s currently juggling finances for five similarly shafted clients. “They call me when in tears,” he told me. “I’m ending up like judge and jury combined, and the job is not a pleasant one.”
The IRS expects that 3.6 million tax returns for 2009 will mention canceled debt, indicating that taxes will be due on primary homes, vacation and rental property, credit cards, auto leases and other canceled debts, and projects that this number will rise in years to come. One of the drivers for this is likely to be HAMP’s call in March this year for more loan forgiveness – as usual, Washington gives with one hand, and then takes back at least some with the other.
While it’s true that the 2007 Mortgage Forgiveness Debt Act allows for up to $2 million loan forgiveness tax, the small print requires that the obligation must have been acquired before 1 January 2009, and spent on a primary residence only.
The twin-headed monster enters stage when either the forgiven debt was taken out during 2009 or later, or an earlier second mortgage was spent on other things, for example school fees, medical bills, transport or even holidays.
What happens where the levied taxes are simply unaffordable? The IRS may allow an installment plan but is unlikely to forgive completely. “The problem is unlikely to disappear completely,” the Keystone CPA told me, “unless, that is, a taxpayer pleads insolvency. But even then it’s seldom simple.
“For example, if a taxpayer’s liabilities are $500,000 and their assets are $300,000, then the $200,000 difference is the extent of their insolvency – but, if the same person has $250,000 in debt canceled, then the additional $50,000 becomes taxable income.”
“People think their house was underwater, so they’re insolvent and can get out of owing taxes,” Arthur Auerbach, a member of the Individual Income Tax Technical Resource Panel at the American Institute of Certified Public Accountants told me. “But it doesn’t [always] work that way.”
Are you considering walking away from a debt that’s facing foreclosure?
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