Income tax liability for imputed income from debt forgiveness is a big issue for people contemplating a strategic defaults or doing short sales related to mortgages on an investment property. There is imputed income from debt forgiveness on your primary home through 2013, but no such exemption exists for debt forgiveness following foreclosures on investment property. Insolvency is a defense.
A property owner who shows he is insolvent does not have to pay tax on imputed income when the bank forgives personal mortgage liability either after a foreclosure or as part of a short sale arrangement.
An attorney asked me about his client who arranged for a short sale of investment property in 2011. The attorney had negotiated a forgiveness of debt on the client’s behalf. The owner has a large retirement fund, but not counting the creditor exempt retirement account he was insolvent. In 2012, the same homeowner filed bankruptcy. Bankruptcy is per se insolvency for tax purposes. Two questions: are exempt assets such as retirement account considered for insolvency, and if so, must the homeowner have filed bankruptcy
in the year of the foreclosure (2011).
Both of these questions are tax issues more than legal issues. I asked a very experienced tax CPA. He says that for tax purposes all exempt assets count when you assess a taxpayer’s insolvency. Even if the mortgage lender could not levy upon the owner’s retirement account the value of the account would preclude the owner from claiming insolvency for tax purposes.
The CPA says that the owner must be insolvent in the same tax year as the debt forgiveness in order to avoid imputed income from deficiency waiver. Homeowners who want to file bankruptcy primarily to avoid imputed income must file in the same year as the debt forgiveness.
In many cases a lender will not formally waive a deficiency until long after the foreclosure so there is no rush to file bankruptcy. However, debt forgiveness related to a short sale will occur simultaneous with the shore sale. People who are trying to negotiate a short sale on an investment property with a deed in lieu of personal liability must consider the tax effect in the year of the sale. If the owner is insolvent under the IRS definition of insolvency there is no problem. Solvent owners may want to consider bankruptcy in same year as the short sale and forgiveness of personal liability