The cancellation of your primary home debt is not considered income provided that the debt was used to purchase the home and was not increased by a cash-out refinance.
Ideally you, just like everyone else in your situation, would like to avoid filing bankruptcy to avoid further embarrassment and credit damage. If you could avail yourself of the insolvency exception to avoid recognizing income from the rental property's debt discharge, you would be able to avoid bankruptcy.
It is a long-established principle of taxation that a discharge of debt results in a gain to the debtor. The reasoning is that when the loan originated, you didn't recognize income because you're obligated to repay it. If you don't repay it, you have somehow gained. Many people in foreclosure don't feel like they've gained anything. However, the bank's loss was caused by your mistake in investment and when the bank isn't repaid, you're being held accountable for its loss.
For many years, the tax law has given bankrupt and insolvent taxpayers a break when it comes to forgiven debt. The reasoning is that the tax law shouldn't take a bad situation and make it worse. It's pretty well established that if you enter into bankruptcy, certain assets, depending on your state of residency, are exempt from creditor claims. Generally, these assets are homestead property, insurance products and retirement accounts. What had not been clear is how these assets were treated in the case of insolvency; neither the law, IRS regulations, announcements or rulings explained it.
A taxpayer in bankruptcy proceedings can exclude forgiven debt from income. A taxpayer that is insolvent can also exclude forgiven debt from income to the extent insolvent. Insolvency means that a person's liabilities exceed their assets. Hence, the definition of assets is extremely important in determining the extent to which a person is insolvent.
Prior to the real estate crisis, the IRS took a taxpayer's claim of insolvency to tax court. The taxpayers sought to exclude assets exempt from creditor's claims when measuring insolvency. The theory being that if the assets are exempt in bankruptcy proceedings, the taxpayer shouldn't be forced into bankruptcy just for the favorable tax consequences. The IRS and the U.S. Tax Court couldn't have disagreed more.
Hence, in determining the extent of your insolvency, you will have to count your 401(k) as an asset. I recommend you have your tax adviser work out the consequences more concisely so that you can measure the benefit of declaring bankruptcy.
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