Paying taxes on forgiven debt

Free Money Finance recently had a post regarding paying taxes after your house is foreclosed on.

This is true, any debt you are forgiven is subject to taxation as regular income. There are several exclusions however, so one may apply to you to remove you of such an obligation. As one FMF commenter pointed out, you are excluded if you are insolvent.

To read all the rules of this exclusion, refer to IRS Publication 908. The relevant excerpt follows:

Insolvency exclusion. You are insolvent when, and to the extent, your liabilities exceed the fair market value of your assets. Determine your liabilities and the fair market value of your assets immediately before the cancellation of your debt to determine whether or not you are insolvent and the amount by which you are insolvent.

Exclude from your gross income debt canceled when you are insolvent, but only up to the amount by which you are insolvent. However, you must use the amount excluded to reduce certain tax attributes, as explained later under Reduction of Tax Attributes.

Example.

$4000 of the Simpson Corporation's liabilities are cancelled outside bankruptcy. Immediately before the cancellation, the Simpson Corporation's liabilities totaled $21,000 and the fair market value of its assets was $17,500. Because its liabilities were more than its assets, it was insolvent. The amount of the insolvency was $3,500 ($21,000 — $17,500).

The corporation may exclude only $3,500 of the $4,000 debt cancellation from income because that is the amount by which it was insolvent. It must also reduce certain tax attributes by the $3,500 of excluded income. The remaining $500 of canceled debt must be included in income.

More general information about canceled debts can be found in IRS Publication 17, specifically:

Generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. You have no income from the canceled debt if it is intended as a gift to you. A debt includes any indebtedness for which you are liable or which attaches to property you hold.

Thus, you are taxed on it. It could also push you into a higher tax bracket, so you will end up paying more taxes overall for that year as well.

And foreclosures? Yep, they are included:

If your financial institution offers a discount for the early payment of your mortgage loan, the amount of the discount is canceled debt. You must include the canceled amount in your income.

There is some good news however. If you decide to repay your debts in full within 3 years, you can get a refund from the IRS. There are other exclusions as well, so if you are faced with this situation I recommend you read the entire section and 908.

Of course, you could always try to get your bank to report the forgiven debt as a gift.

Here's an article written in non-IRS speak: Lose Home, Pay More Tax