calculating insolvency (re: debt cancellation)

[dcfan]

What is the name of your state (only U.S. law)? California

I lost a house to foreclosure in 2008. It was not my primary residence. I have read that if I was insolvent immediately before the foreclosure, then I will not be taxed on the cancellation of debt. I pretty much understand how to calculate insolvency except for one big question.

As I add up my liabilities prior to the foreclosure, do I include the mortgage itself (on the same property that I lost in the foreclosure)? I would think so, since it is most definitely a liability I had immediately prior to the discharge of the debt, yet there is something circular about the logic (couldn't pay the debt because i had the debt?) that makes me doubt.

I have no savings or property or other assets, and the house in question had no equity (I had been paying zero-down, interest-only for 2 years). So my assets are close to zero. The mortgage of $180,000 far exceeded the value of the house by maybe $60,000. Am I right in thinking that since I had no equity in the house, I had a liability of 180,000 and was therefore insolvent to the degree of nearly 180,000, thereby protecting me from tax on the cancellation of this $60,000 debt?

 

[LdiJ]

What is the name of your state (only U.S. law)? California

I lost a house to foreclosure in 2008. It was not my primary residence. I have read that if I was insolvent immediately before the foreclosure, then I will not be taxed on the cancellation of debt. I pretty much understand how to calculate insolvency except for one big question.

As I add up my liabilities prior to the foreclosure, do I include the mortgage itself (on the same property that I lost in the foreclosure)? I would think so, since it is most definitely a liability I had immediately prior to the discharge of the debt, yet there is something circular about the logic (couldn't pay the debt because i had the debt?) that makes me doubt.

I have no savings or property or other assets, and the house in question had no equity (I had been paying zero-down, interest-only for 2 years). So my assets are close to zero. The mortgage of $180,000 far exceeded the value of the house by maybe $60,000. Am I right in thinking that since I had no equity in the house, I had a liability of 180,000 and was therefore insolvent to the degree of nearly 180,000, thereby protecting me from tax on the cancellation of this $60,000 debt?

No, you are not correct.

The fair market value of the house goes on the asset side of the equation, and the mortgage balance goes on the liabilities side.

If you had no other assets, and no other debts, and the FMV was 120k and the mortgage was 180k then you are insolvent by 60k. Therefore 60k is the maximum amount of canceled debt that you can exclude from income, under insolvency.

If you have a car or household furnishings, the FMV of those goes on the asset side. If you have any credit card debts, student loan debts, balance due on a car loan etc., those go on the liability side.

 

[dcfan]

Thanks for your answer. It was very helpful. Now let's see if I understand then...
Using the same example, if my house was foreclosed on with a mortgage of $180,000 and a FMV of $120,000, and I had no equity, that means that my cancellation of debt is in the amount of $60,000 - the mortgage less the fmv?

And by what you just explained, if for the purposes of simplicity I had no other assets or liabilities, I would be insolvent to the degree of $60,000 also?

So effectively, the whole canceled debt would in that case be excluded from my so-called income?

Since, apart from the house, my other liabilities also outweigh my assets, I am thinking that I will not have a tax liability here.

I hope this is right, but I am wondering if perhaps the cancellation of debt is in the amount of the full $180,000 without the offset of the house's fmv.

Thanks again.

 

[LdiJ]

Thanks for your answer. It was very helpful. Now let's see if I understand then...
Using the same example, if my house was foreclosed on with a mortgage of $180,000 and a FMV of $120,000, and I had no equity, that means that my cancellation of debt is in the amount of $60,000 - the mortgage less the fmv?

And by what you just explained, if for the purposes of simplicity I had no other assets or liabilities, I would be insolvent to the degree of $60,000 also?

So effectively, the whole canceled debt would in that case be excluded from my so-called income?

Since, apart from the house, my other liabilities also outweigh my assets, I am thinking that I will not have a tax liability here.

I hope this is right, but I am wondering if perhaps the cancellation of debt is in the amount of the full $180,000 without the offset of the house's fmv.

Thanks again.

The cancelation of debt must be offset by the FMV of the house. The lender cannot give you a 1099C for the entire debt, without disclosing the FMV on the 1099C so that it can be offset.

 

[davew128]

There are other issues in play here, such as the tax basis in the property and whether the loan is non-recourse. In CA, most original mortgages are non-recourse. This does change things a little bit and I strongly suggest you seek local counsel as cancellation of debt isn't the issue you're dealing with when the debt is non-recourse. You could be facing a capital gain instead. Or not if you had an interest only loan after you bought it. Again, seek out a local tax pro.