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How to avoid Federal taxes on short sales and other debt settlements

Generally speaking, whenever you settle a debt for less than you owed, the difference counts as income – taxable income.

A short sale is a form of debt settlement, and the difference between the amount you provide to satisfy the mortgage, and the amount owed on the mortgage, is your deficiency.

Mortgage value – Short sale value given to the bank=Deficiency

The deficiency on your loan is liable to Federal taxation as a canceled debt, which would typically be included as income on Form 1040/1040NR, line 21.

However, the Mortgage Forgiveness Debt Relief Act of 2007 established a powerful exclusion for debt cancellations as long as they are forgiven on your mortgage for a primary residence.

The ‘qualified principal indebtedness exclusion’ provides that up to the value of the mortgages you have taken out solely for the purpose of investing in the home property are not taxable. Home equity loans count toward this exclusion, but only if they were taken out for the sole purpose of upgrading the property.

Second properties or home equity lines of credit, which were applied to your other debts could be taxed. But you might even be able to avoid taxes on these debt settlements by claiming insolvency on your tax return.

Proving insolvency for your IRS tax exclusion on debt cancellation

Anyone who files for bankruptcy will not be required to pay taxes on the discharged debt. But in addition, your debt negotiations are not taxable as long as they are less than the quantity of your insolvency. Let me explain.

To prove insolvency, fill out Form 982, selecting box 2 under Part I. You must also provide documentation, which assesses your assets against your liabilities. You are insolvent to the extent that your liabilities exceed your assets. If you have large debts on credit cards, student loans or any other judgments against you, then you may be insolvent.

The negative balance is your cushion for Federal taxes on debt settlements.

For example: if you prepare the insolvency worksheet and find you owe $10,000 more than what you own, and you settle a debt for a $50,000 debt cancellation, then you would need to pay taxes on the difference.

$50,000 in reduced debt -$10,000 insolvent=$40,000 taxable income

Welcome to the semi-taxable world of financial solvency.


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