Will Congress give retroactive Short Sale tax breaks to the to 2014 and resolve it in 2015?
Anna McClusky 11/19/14
The Mortgage Forgiveness Debt Relief Act (MFDRA) expired December 31, 2013. This tax break offers forgiveness for homes that are short sold, and the remaining debt that was forgiven is taxed similar to capital gains, leaving some home owner's, already struggling with a huge tax burden!
The Senate Finance Committee voted to approve the break for the 2014 and 2015 tax years. However, provision remains part of a larger package of expired breaks that is bogged down in Congress. Experts in the industry seem to agree that action to extend, modify or terminate the Act is doubtful until after the 2014 midterm that just past in November.
If you are underwater on your home mortgage and need to sell your house, what do you do?
IRS “Insolvency Clause” Offers Tax-Saving Alternative
Here’s an example of how the Insolvency Clause works-
Short sale sellers can still be exempt from tax liability under the “insolvency clause” of the Internal Revenue Code. The clause states that a seller is exempt from paying tax on any forgiven debt to the extent that they are insolvent. In other words, if the seller’s debts and liabilities exceed their assets by more than the amount of debt forgiven, they do not have to pay taxes on the forgiven debt.
A seller has a home valued at $300,000, but the mortgage debt is $400,000. We short sell the property for $300K and the bank elects to forgive the debt on the $100,000 shortfall amount. Since debt that has been forgiven counts as taxable income, the IRS would treat the $100,000 of forgiven debt as income.
MORTGAGE DEBT $400,000
SALE PRICE -$300,000
FORGIVEN DEBT(Taxable income) $100,000
This is where the insolvency clause formula comes in. Begin by adding up all of your debts/liabilities in one column and all of your assets in another. For this formula, the IRS wants you to include the mortgage debt as a liability, and the fair market value of your house as an asset.
ASSETS $300,000
LIABILITIES -$400,000
INSOLVENCY ($100,000)
Since your insolvency amount of $100,000 equals the forgiven debt amount of $100,000, it’s a wash and you will not have to pay taxes on that forgiven debt. You are shielded dollar-for-dollar on the amount of forgiven debt up to your insolvency number. Let’s say you were only insolvent by $60,000. In that case, you would still have to pay income tax on the remaining $40,000 of forgiven debt.
INSOLVENCY ($100,000)
FORGIVEN DEBT -$100,000
TAXABLE INCOME $0
Here’s an example of how the Insolvency Clause works-
Short sale sellers can still be exempt from tax liability under the “insolvency clause” of the Internal Revenue Code. The clause states that a seller is exempt from paying tax on any forgiven debt to the extent that they are insolvent. In other words, if the seller’s debts and liabilities exceed their assets by more than the amount of debt forgiven, they do not have to pay taxes on the forgiven debt.
A seller has a home valued at $300,000, but the mortgage debt is $400,000. We short sell the property for $300K and the bank elects to forgive the debt on the $100,000 shortfall amount. Since debt that has been forgiven counts as taxable income, the IRS would treat the $100,000 of forgiven debt as income.
MORTGAGE DEBT $400,000
SALE PRICE -$300,000
FORGIVEN DEBT(Taxable income) $100,000
This is where the insolvency clause formula comes in. Begin by adding up all of your debts/liabilities in one column and all of your assets in another. For this formula, the IRS wants you to include the mortgage debt as a liability, and the fair market value of your house as an asset.
ASSETS $300,000
LIABILITIES -$400,000
INSOLVENCY ($100,000)
Since your insolvency amount of $100,000 equals the forgiven debt amount of $100,000, it’s a wash and you will not have to pay taxes on that forgiven debt. You are shielded dollar-for-dollar on the amount of forgiven debt up to your insolvency number. Let’s say you were only insolvent by $60,000. In that case, you would still have to pay income tax on the remaining $40,000 of forgiven debt.
INSOLVENCY ($100,000)
FORGIVEN DEBT -$100,000
TAXABLE INCOME $0
Here's hoping Congress does the right thing in honoring and holding this tax credit retroactive for 2014 and honors it for 2015 as well. If you have nothing to give, there's no sense trying to take.
