December 31, 2013 marked the expiration of the Mortgage Forgiveness Debt Relief Act which means homeowners are no longer protected from being taxed on their forgiven mortgage debt after going through a short sale or foreclosure.  A short sale can now only qualify for the Act’s tax exemption if the transaction was closed before the December 31, 2013 expiration date.  Mortgage debt that is forgiven by a lender is normally considered taxable income without the Mortgage Forgiveness Debt Relief Act, but the IRS is offering a way for people to avoid being taxed on forgiven mortgage debts.

IRS “Insolvency Clause”

Homeowners that are facing a short sale or foreclosure and are worried about having to pay taxes on their forgiven debts may not be aware that they could qualify for tax relief through the IRS “insolvency clause.”  With this clause, a seller is exempt from paying taxes on a forgiven debt to the extent that they are insolvent.  What this means is that if the amount of a seller’s debts and liabilities is greater than their assets by more than the portion of the debt forgiven, they are exempt from paying taxes on the forgiven debt.

Example of the “Insolvency Clause”

For this example, a homeowner has a house worth $200,000 but a mortgage debt of $350,000.  The owner short sells the home for $200,000 and the bank forgives the remaining debt of $150,000.  This forgiven debt is initially treated as taxable income by the IRS.

Now the principles of the insolvency clause can be applied. First, add up all debts and liabilities as well as your assets. The IRS expects you to list the mortgage debt as a liability and the fair market value of the house as an asset. If your total assets amount to $500,000 and your liabilities are $650,000, you have a $150,000 insolvency.

In this scenario, the insolvency amount of $150,000 matches the forgiven mortgage debt of $150,000 which makes the homeowner exempt from paying taxes on the forgiven debt. Every dollar of the forgiven debt is protected up to the insolvency amount. So if the insolvency in this scenario was $100,000, the homeowner would still pay income tax on the remaining $50,000 of the forgiven debt.

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