Avoid Taxes on a Short Sale
The Internal Revenue Code provides for an insolvency exclusion which exempts forgiven debt for a taxpayer, to the extent of their insolvency. Insolvency is the difference between the taxpayer’s outstanding liabilities and the fair market value of all assets held on the date of sale or debt forgiveness. To the extent that the taxpayer’s liabilities are greater than the value of the assets, that difference can be used to exclude cancellation of debt income from taxable income.
For example, assume the taxpayers liabilities, including the mortgage debt forgiven, total $500,000 and the fair market value of all the assets, including the property sold, total $200,000. The difference ($500,000-$200,000) of $300,000 is the extent of their insolvency. That means up to $300,000 of 1099-C income can be excluded from taxable income. Assets used in this calculation include creditor protected assets, such as retirement accounts.
A borrower should never assume that they qualify for this exemption by virtue of the fact that there is negative equity in their home. To determine eligibility for the insolvency exclusion, a detailed analysis of a taxpayer’s assets and liabilities would need to be performed. This exclusion is available for investors. Please see the attached link below for more detailed information on this exclusion and make sure to get an opinion from a professional tax advisor.