First Foreclosure and Now a HUGE Tax Burden! What’s Next?

by Tim Krulia – Private Money Blueprint CFO

As part of our quest here at PMBP to give you the single best resource on the financial aspects of growing your real estate investing business (aka, we help people find private money quickly, easily, and abundantly)… here’s an article I found that helps explain why forgiven debt is considered income and taxed accordingly…

This article is great because it gives a clear explanation of some of the ways that the IRS does and doesn’t forgive tax liabilities that can come from foreclosures and short sales.  Since we are in the real estate world, I think it’s great to at least be knowledgeable about some of the tax laws that are out there affecting real estate.  After reading this article, when you’re talking to a client, friend, customer, etc. and the topic comes up over whether or not someone is going to get a big tax debt from their foreclosure or short sale, you’ll have something intelligent to tell them.

The article’s author did a great job listing 4 big exceptions to the rule of the IRS allowing a lender’s forgiveness of debt not to be considered taxable income.  He also mentions that even if an individual does unfortunately fall into one of the 4 categories where the tax liability isn’t erased, that he/ she could still get off the hook so to speak.  One route mentioned was bankruptcy.  That’s an “ouchy” one that can hopefully be avoided.

The other one he mentions is insolvency.  Insolvency, as I understand it, basically is just someone who can’t meet their debt obligations.  I know that this is a better fit question for an experienced CPA or tax attorney to determine who is or isn’t legitimately insolvent per the IRS, but wouldn’t just about anyone who had to let their house go to short sale or foreclosure do so because they couldn’t meet their debt obligations?  It sounds like there’s a lot of grey area in there, and if you’re talking to someone who is faced with a possible big tax debt from losing a house it may be nice of you to tell them to dig into it a bit before giving up and accepting the nasty tax debt.

Here’s something else that of course is specific to each individual’s situation and again, definitely something that an experienced CPA or tax attorney should counsel someone on (and I’m not either one), but I would suspect that there is one other BIG way erase a bundle of the tax debt of forgiven debt that has to be considered as income in the eyes of the IRS.  Follow me here…

It seems like most investors have a business that they run and it seems like most are legally structured as LLC’s, right?  Since an LLC is a flow though entity for taxation, wouldn’t an investor be able to show the loss on their books for the difference between where they bought the property and “sold” it?  I’d assume, yes.  If so, that’s pretty great because let’s say someone lost their property to a short sale for example, and the lender ended up loosing say $50,000 from all the chaos.  If you’re situation falls into one of the 4 criteria that the IRS won’t let you off the hook reporting that as income, you’ve just added $50,000 to your adjusted gross income (yuck!).  If the house took a loss of let’s say $40,000 from where you bought it to where you sold it, then that should be a write off, right?  If so, the taxable income would only be $10K!

Maybe I’m making this sound too easy in my head, but it seems pretty obvious to me.  At least I’d pose the question to an experienced CPA or tax attorney.  It could be a pretty darn clean and easy way to eliminate what could be an ugly tax bill as the article discussed.  Anyone know someone who’s been faced with this situation and how it worked out for them on their taxes?