Insolvency + Tax Season = Good News?

After seeing yet another prominent news article grousing about the tax consequences of short sales and other forms of mortgage relief, I thought I'd pass along a discovery I made a few years back that seems to be ignored over and over in the popular press. Bottom line: the "income" from cancellation of debt (e.g., from a mortgage modification) is often NOT taxable to the debtor.

Yes, the specific tax exemption for this kind of "income" expired last year.  But there is another, more widely applicable exclusion. IRS Pub. 4681 explains the tax consequences of many kinds of "cancellation of debt (COD) income." The focus is on exclusions for COD income incident to mortgage modifications and formal Title 11 bankruptcy cases, but it also discusses another lesser-known exclusion: the "insolvency" exclusion. If the debtor was balance-sheet insolvent (total debt in excess of FMV of all assets, including secured collateral and seizure-exempt assets) both before and after the cancellation of debt, the ordinary income from the canceled debt is excluded from taxable income to the extent of the insolvency.

So if a lender forgives $50,000 of debt in a mortgage modification (or other workout), the debtor would ordinarily recognize $50,000 in ordinary "COD" income and owe a big chunk of marginal-rate tax. But if the debtor still has other remaining debts at least equal to the FMV of all of his/her remaining assets, the cancelled debt is not taxable, as it is entirely offset by the pre-COD insolvency. If the debtor's assets exceed the value of his/her remaining debts by $30,000, that $30,000 is solvency created by the fogiveness; that's real value that the IRS will tax as ordinary income. But $20,000 of the COD income is excluded from ordinary income and not taxed. My bet is that many (if not most) people who get a major mortgage modification remain insolvent, at least barely and at least technically, following the modification, reducing or eliminating taxable income from the forgiveness. Of course, if the forgiveness is in the 6-figure range, that might well produce post-forgiveness solvency to be taxed, but the exclusion is still a major boon for all kinds of debtors who receive workouts with partial forgivenss of student loans, mortgages, taxes, etc.

The problem, as Bryan Camp of Texas Tech Law School points out in this great article, is procedural. The taxpayer, or her/his accountant, has to know about and claim this exclusion from income, especially if the debtor receives a 1099-C from the lender, reporting the COD income to the IRS. H&R Block and other mainstream tax preparers will seldom consider whether the insolvency exclusion applies (based on what I've often heard from bankrutpcy lawyers and others about tax preparer treatment of this kind of transaction). So this tax law wrinkle might well not solve all of the problem described in the NYT article linked above, but it ought not to be overlooked by debtors and their lawyers.