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Bankruptcy May Be Your Option

Income from Cancelation of Debt

Generally, if a debt you owe is canceled or forgiven, you must include the canceled amount in your income on your tax return (26 U.S.C. § 108). This can have a significant impact for those individuals who are forced to walk away from their home and then are faced with an income tax liability for doing so. However, exceptions to this general rule exist. The most notable exceptions are debts canceled or discharged in bankruptcy or if the borrower is insolvent.

In order to apply the Bankruptcy exception, the petition in bankruptcy must be filed before the lender cancels the debt. In Oklahoma under 12 O.S. § 686, the foreclosing lender must file a motion to enter a deficiency against the borrower within 90 days of the foreclosure sale. If the lender does not file the motion in the foreclosure action, the deficiency is canceled. This means that if your home is in foreclosure, you must file your bankruptcy before the expiration of 90 days from the Sheriff's Sale in order for the exception to taxable income to apply. This does not mean that a lender cannot cancel the debt before the expiration of the 90 days, so a borrower wishing to discharge the deficiency and the tax liability must act quickly.

In order to apply the insolvency exception, the canceled debt is excepted from income to the extent the borrower is insolvent. The time to determine insolvency is immediately before the cancellation of the debt. A borrower is insolvent to the extent their liabilities excess the fair market value of their assets. Assets, include the value of everything the borrower owns, including furniture, clothing, vehicles, pension and retirement plans, etc. In most cases, the IRS will accept the list of assets and liabilities the borrower files in a bankruptcy. If you live in Tulsa or Northeastern Oklahoma, contact The Colpitts Law Firm as soon as possible to discuss foreclosure and preserve your bankruptcy and non-bankruptcy options.

For tax years 2007 through 2012, a special rule applies. The Mortgage Forgiveness Debt Relief Act may eliminate a borrower's cancellation of indebtedness income if the debt was secured by the residence and was a debt used to buy, build or substantially improve the borrower's residence. The maximum debt that qualifies for this exclusion is $2,000,000.00 ($1,000,000.00 if married filing separate).

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