I have another approach to explain why he DID have a gain.
All money that becomes yours, except as allowed by law, is taxable as income or capital gains or whatever.
When you borrow money, you receive the money (to buy a house, boat, RV or lawn furniture or whatever), but the money is not yours - you have to give it back to its owner.
When the owner of the money YOU ALREADY HAVE and may have already used (such as buying a house), tells you that you do not have to give it back, the money slides from his column (his money) to your column (your money). That’s when it becomes taxed.
The fact that you may have received use of the money many years ago is not relevant. Its when ownership of the money changes that it is counted as income. The fact the cash may already be long gone is also not relevant, because the cash did arrive at some point. But once you do not have to pay it back, then the ownership becomes yours and its income.
There are only two ways to discharge this. (1) pay back the money that was borrowed so that it does not become “yours” or (2) bankruptcy (not a complete solution any more).
The IRS is very unlikely to budge on this as it is well established that any money you receive ownership of is taxable. The only issue is how its taxed and when its taxed.
Cancellation of Debt on a Forclosure in IL?? - Posted by IL Investor
Posted by IL Investor on May 29, 2007 at 15:15:35:
Hey folks,
Unfortunately, this is a specific question when I know that note asks you not to.
Anyway, a good friend of mine had his house forclosed when he was trying to sell it (couldn’t get it sold in time, basically) and I feel guilty because I was trying to help him, and basically failed to do so in a timely manner (although by the time I knew about it, I did only have about a month to wrap it up before it was too late).
When he purchased the house, he did a combo mortgage with a 1st and 2nd lien to cover the note.
Here we are, about a year after the forclosure, and he gets this paper saying he owes taxes on his ‘gain’ from the second mortage (as best as I can understand it) even though the house was forclosed and no gain was realized.
From what I was told by another investor in St. Louis, it’s a fairly common problem that people can usually get dismissed with an hour or two pay to a CPA or Real Estate lawyer, however I’ve never dealt with this myself.
He’s a good friend of mine and he’s freaking out thinking he owes the government tax on this money which he never really benefited from due to the loss of the house, so we’re trying to figure out the best route to go.
I have a scan of the actual document if anyone wants to take a look at it for clarification and I’m basically wondering what folks around here have experienced in this regard, and what you might recommend in order to quash the issue and handle it as completely as possible.
Re: Cancellation of Debt on a Forclosure in IL?? - Posted by Natalie-VA
Posted by Natalie-VA on June 05, 2007 at 13:41:21:
It’s possible that he might not owe tax if he can show the IRS that he was insolvent. The important thing to do here is take yourself out of it and refer him to a competant CPA. You tried to help him before and that didn’t work out. If you really want to help him, send him to someone who is qualified to help.
Asked my brother in law (tax attorney) this a couple weeks ago. Forgiveness of debt (any money not covered by the sale of the house) is regarded by the IRS as taxable income.
Let me try this again. Cancellation of a debt IS income, and its the IRS who calls it that, so there is little to no chance you can get them to change their minds. Think of it this way.
When you borrow money (credit card, mortgage, etc.), the owner lends you their money to use. Its still their money. At this point you have possession of the money (or whatever you bought with the money) but not ownership of the money. You have to pay it back.
When the owner says you no longer have to pay some or all of the money back, the ownership of that amount of money slides from their column to you column. When ownership of the money changes hands, tax is owed. The fact that the money was spent and you no longer have the item you bought means nothing to the process. Taking ownership of money is all that is required to trigger tax.
Do not confuse the taking possession of money with ownership of the money. You can get possession many years before (such as buying a house) and get ownership of the money much later (such as when the house is sold for less than owed and the lender decides not to pursue a deficiency judgment - forgiving some of the debt).
A gain is NOT profit. A gain is when you become owner of some money, whether you have the cash to spend or not.
A similar circumstance occurred with the DOT COM bust. A lot of people exercised their stock options, saw them go up and then pop, nothing left. Yet with these worthless pieces of paper came a huge tax bill. The tax was owed based on the prices they bought the stock at (since stock options offered discounted purchases of the company’s stock), not based on the fact the stock was now worth nothing.
Whenever you come into ownership of money, even if the ownership is merely on paper, you owe tax. The only question is how it will be taxed and how much.
There is only one way to “quash” a “cancellation of debt”. Pay it back. If the house sold for less, then pay back the difference (the deficiency). The “gain” in the former home owner’s column is based on how much was owed, NOT how much the house sold for. That difference is taxable income and it is very unlikely that the IRS will suddenly change direction and no longer consider it as income.
I know this is not the answer you WANT to hear. You can, and should, verify this with a tax attorney. i have found out that many will answer this type of question for free just on your initial phone call.