Avoiding Tax on Short Sale

Dear Tax Talk, I'm a seller going through a short sale right now. My job relocated, and I couldn't afford to keep the property. I also was barely getting by to pay the mortgage. The bank accepted an offer from a buyer and the short sale is about to close.

I filled out the Form 1099 the escrow company provided. But I'm waiting for next year when the government will hit me with a huge tax bill (as though I earned income on this short sale -- due to the debt forgiveness.)

My situation was: I don't think I had any assets with value. My car was underwater, my house was underwater, I had an IRA with only $1,000 in it and my bank account was negative each month during the period I was in the home.

Can I claim insolvency? If so, where and when do I begin? -- Brian

Dear Brian, Insolvency is certainly one exception that will allow you to avoid a tax bill on the short sale. An insolvent taxpayer does not have to include canceled debt in income to the extent insolvent. You are insolvent if immediately before the short sale the total of all of your liabilities is more than the fair market value of all of your assets. Because the only thing positive you have is $1,000 in an IRA, and your bank accounts are negative, then you'd probably be considered insolvent. When you receive the 1099 for 2011, you'll need to complete Form 982 to claim the insolvency exception.

While the insolvency exception is helpful, it may not solve your tax burden if you have certain assets with value that you may not have considered. For example, in bankruptcy certain assets are exempt that the Internal Revenue Service does not consider excludable for measuring insolvency. Principal among the differences are insurance products and retirement accounts. While generally these are exempt from creditors' claims in a bankruptcy, they are includable for purposes of measuring insolvency. You're basically driven into bankruptcy if you want to avoid the tax bill. While insolvency does not show up on your credit report, bankruptcy can hurt you for years to come.

Another item affecting insolvency is the value of business interests. If you're self-employed, the IRS could contend the value of any business you own is sufficient to overcome your insolvency.

If you can't meet the insolvency exception and the rules relating to principal home debt forgiveness do not apply, you may very well have to look at bankruptcy to avoid the tax bill.

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