Insolvency and the Forgiveness or Cancelation of Debt

June 24, 2014

In recent years, homeowners facing foreclosure may have had the debt owing on their mortgage after the sale of their property, known as a deficiency, waived (or forgiven) by the mortgage company. If a homeowner had the deficiency waived, the waived amount is known as canceled debt or discharged debt, and will likely be seen as taxable income by the IRS. As of January 1, 2014, the exception which allowed for canceled debt for one’s own personal residential debt to not be treated as taxable income expired. As a result, now, if the bank is able to foreclose on the homeowner’s house, but is willing to waive the amount owed after the sale of the house, a homeowner may be facing a situation in which he or she has to pay taxes on what is seen as income as the result of canceled debt.

However, there is an exception if you are insolvent. Insolvency means a person’s liabilities are in excess of the fair market value of his or her assets. The Tax Code, under Section 108, provides that if debt is discharged (or canceled) when you are insolvent, the discharged debt will not be seen as income, and thus you won’t pay taxes on this. But there is a limit on this exception; to the extent the discharged debt makes on solvent, the amount you become solvent will be seen as income, and thus taxed.


That can be confusing. The important thing to focus on here is the time at which the debt is discharged. If at that time the debt is discharged you are insolvent, and you are insolvent after the debt is discharged, then the discharged debt will not be seen as income, and thus not taxed. If at the time the debt is discharged you are insolvent, but the you are no longer insolvent after the debt is discharged, then the amount by which you become solvent is considered income, and will be taxed.


Examples will illustrate this. Let’s say you’re only assets and liabilities consist of your house and the mortgage you owe on it. Assume the fair market value of the house is $80,000, but the mortgage owing is $150,000. You would have assets in the amount of $80,000, and liabilities in the amount of $150,000. As your assets are clearly lower than your liabilities, you are insolvent by $70,000. Say the foreclosure is entered, and your mortgage company decides to waive the deficiency. It sells for $80,000, and so the mortgage company discharges the remaining $70,000. You were insolvent before the debt was discharged. You would also be insolvent after the debt is discharged. Your assets would not be higher than your liabilities, and you would still be insolvent. The $70,000 forgiven would not be seen as income.


Instead, let’s imagine you have cash assets of $30,000, and a house with a fair market value of $100,000, but you owe $180,000 on your mortgage, and have $20,000 in credit card debt. Your assets would be $130,000 and your liabilities would be $200.000. So you would be insolvent. If the mortgage company forecloses, but sells the house for $100,000 and forgives $80,000, then at that time your assets would be $30,000 and your liabilities would $20,000. You would have become solvent as a result of the $80,000 debt being discharged, but only by $10,000 ($30,000-$20,000). Your income would be considered to be $10,000, not $80,000.


These are of course only examples, and other factors may come into play when you are doing your taxes. Please consult a professional tax accountant or attorney to discuss your individual situation, should you have questions about insolvency and discharged debt.